Golden Retriever (golden.retriever@dogs.k9.gov) sent us a long email about the previous post. This reminds me I haven’t replied to his previous mail about whether actuaries should be regulated. I didn’t reply because I didn’t know the answer, but UKSA is currently preparing its submission to the BEIS consultation so I may have an answer soon.
In the previous post I wrote
It necessarily follows that there is some cast iron guaranteed way of making money by buying into dips in the credit market. As bond prices fall, buy more bonds in the certainty that they will rise again.
Retriever objects:
If a bond is currently trading below par, then would I not expect to make money by purchasing the bond and redeeming it at par? Not a cast iron guarantee perhaps, but pretty likely surely, since investment grade corporate bonds don’t seem to default very often.
Well “don’t default very often” is relative. The chart at the top shows the observed annual default rate for Baa (S&P BBB) investment grade corporate bonds, to which many life companies are increasingly exposed.
True, they haven’t defaulted very often in the last decade but they defaulted more often in the decade before that, and of course the 1930s was hardly a walk in the park. Remember that life companies have to hold these assets for a very long time, i.e. many decades. Remember also that an annual average default probability translates to a much higher probability when we own the bond for decades. An annual rate of 0.5% translates to a roughly 12% chance of default over 25 years.
Retriever also writes, to the point that if the theory behind MA were correct, hedge funds would have a method of making a guaranteed return on capital:
But isn’t the point that hedge funds tend to have fairly short time horizons, and that bonds close to redemption will be trading close to par – leading to limited scope for making money in the way you suggest? I’d have thought that what you suggest only works if you can hold the bonds for a long time – so it might work for life insurers even if it doesn’t work for hedge funds?
I will address that question (and a few others) in the next post.