Our finding of inferior risk-adjusted return for original issue high-yield bonds turns on its head past claims of superior risk-adjusted returns for the high-yield asset class as a whole.7 High-yield bonds in aggregate outperformed Treasuries on a risk-adjusted basis during 1997-2006, but that edge was more than fully accounted for by the fallen angels, which at no point during the observation period accounted for as much as 31% of total market value.8 One possible construction that can be put on these findings is that the high-yield concept was marketed to investors circa 1977 on the strength of fallen angels' past performance, a record that subsequent original issues failed to replicate. Reducing the disparity between FA and OI in risk-adjusted returns, we believe, requires strengthening of the call protection of original issues. We currently see no evidence that underwriters are eager to introduce such a reform. The persistence of inferior risk-adjusted returns on original issue high-yield bonds represents a bona fide market inefficiency. This market imperfection is confirmed by the success of one group of transactors in capitalizing on the mispricing. Corporate sellers of new issues have collectively escaped paying a default risk premium, based on realized returns, as opposed to promised yields. We propose several explanations for why the anomaly persists: 1. Unawareness of OI segment's underperformance. 2. Focus on security selection. 3. Dependence on new issues to deploy funds. 4. Lottery ticket effect. 5. Mirage of remedy based on yield rather than bond structure. The relative contributions of these factors may be established by future empirical analysis.
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