We classify a bond as a high-grade bond if it is rated as Aaa, as a medium-grade bond if it is rated as Aa1, Aa2, or Aa3, and as a low-grade bond
in all other cases (including the case of no rating), according to Moody's ratings.
Despite the difference in methodology between the Cornell and Green study and the other two studies, all three studies conclude that low-grade bond
returns and resulting holding-period risk premiums are consistent with their systematic risk and that low-grade bonds
are fairly priced relative to high-grade debt.
Finally, stochastic dominance model is applied to show that small stock returns dominant low-grade bond
New merger proposals dropped off noticeably during the first part of 1990 as a consequence of the virtual unavailability of funds for new financing in the low-grade bond
market; the more cautious attitude of commercial banks, both domestic and foreign; and the weakening in the market for asset sales.
Kihn, J., 1994, "Unravelling the Low-Grade Bond
Risk/Reward Puzzle," Financial Analysts Journal (July/August), 32-42.
Cornell and Green (1991) rely on the returns for low-grade bond
funds to estimate the risks and returns for these bonds.
On the one hand, Reilly (1994) reports that investment houses regard the securities as "low-quality credits that have characteristics of common stocks." Shane (1994) writes, "A low-grade bond
can be viewed as a hybrid security consisting of a government bond and a claim on the issuing firm's equity." Economist Lawrence Summers more colorfully characterizes certain types of high-yield issues as "equity in drag."(1) In sharp contrast, Christensen and Faria (1994) deny that high-yield debt behaves like equity.
For example, low-grade bonds
are generally considered less liquid than investment-grade bonds; as such, the yields observed in the market for low-grade bonds
will generally reflect a higher illiquidity premium than investment-grade bonds.
Salter suggested a mix of 2% low-grade bonds
, 30% large-cap, 24% mid-cap, 20% small-cap, and 24% international stocks, the latter preferably within a managed fund.
Researchers have found systematic differences among returns for different months of the year in low-grade bonds
. No fully satisfactory explanation has been provided for this apparent violation of the trading hypothesis.
She adjusted the asset allocation in Michelle's portfolio to 28% large-cap, 24% mid-cap, 24% international, 19% small-cap, and 5% in low-grade bonds
: "This is the best portfolio mix for someone like Michelle who is looking to invest for at least 18 more years and has a moderately aggressive risk tolerance," says Helm.
Keim, in an update of an earlier analyses, discuss the myths and reality of low-grade bonds
. They conclude that low-grade bonds
display characteristics of both small stocks and high-grade bonds.