How can you profit from junk bonds and selling treasuries, if the junk bond doesn't default?

Question

Junk Bond/Treasury convergence

Typically junk bonds, given their speculative grade, are undervalued as people avoid them. Therefore the spread over treasuries is more than the risk of default, by buying junk bonds and selling treasuries, to hedge interest rate risk. Often profits can be achieved by buying junk bonds and selling treasuries, unless the junk bond defaults.

Wikipedia doesn't detail this interest rate hedge. Assume that a junk bond never defaults and the semistrong-form of the EMH:

Zvi Bodie, Alex Kane, Alan J. Marcus. Investments (2018 11 edn). p 338.

      The semistrong-form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. Such information includes, in addition to past prices, fundamental data on the firm’s product line, quality of management, balance sheet composition, patents held, earnings forecasts, and accounting practices. Again, if investors have access to such information from publicly available sources, one would expect it to be reflected in stock prices.

Correct me if I'm wrong, but Treasury bonds' interest usually $<$ junk bonds' interest. So

1. why would anyone rational sell you junk bonds and buy T-bonds from you (so that you can long junk bonds and short T-bonds)?

2. wouldn't this spread over treasuries always be forthwith arbitraged?

Answer 1

1. You assumed that junk bonds do not default. They do default. So people will price junk bonds at a greater yield than Treasuries.
2. It can’t be arbitraged since the probability of default (and associated loss) is unknown. An arbitrage implies locking in an abnormal profit at no risk. You cannot hedge out that default risk without using an instrument like a credit default swap. if you did hedge losses with a credit default swap, the cost of the swap cancels out the yield advantage on the bond (assuming everything priced at fair value).

If we ignore transaction costs - which we cannot in practice - the breakeven spread point for a high yield bond portfolio is where the average spread approximately equals the expected annual loss (= probability of default times loss given default). E.g., a 500 basis point spread (5%) will offset credit losses of 5% a year. (We would need to do a detailed cash flow analysis to map credit losses to spreads, but the approximation is typically quite good for bonds trading near par.)

The credit loss rate is unknown, and opinions differ wildly about them. Observed spreads represent some kind of “average” of market participant’s views (assuming no other factors influence pricing). The first quote just says that the actual credit losses tend to be below what spreads discount across the cycle.

However, high yield bonds are illiquid, and have greater transaction costs, and so need to offer an additional spread to compensate. Meanwhile, markets can be disturbed, such as forced liquidations, and so spreads can trade wider than most market participants’ expected credit losses.

Answer 2

Typically junk bonds, given their speculative grade, are undervalued as people avoid them. Therefore the spread over treasuries is more than the risk of default, by buying junk bonds and selling treasuries, to hedge interest rate risk. Often profits can be achieved by buying junk bonds and selling treasuries, unless the junk bond defaults.

Wikipedia doesn't detail this interest rate hedge. Assume that a junk bond never defaults and the semistrong-form of the EMH:

The text you quote is asserting that junk bonds are undervalued, which contradicts the EMH. So they are asserting the EMH doesn't hold for junk bonds.

Also, assuming that junk bonds never default is bizarre.

why would anyone rational sell you junk bonds and buy T-bonds from you (so that you can long junk bonds and short T-bonds)?

To employ the strategy described in the text you quoted, it is not necessary that the person you buy the junk bonds from be the same person as you sell the treasuries to.

wouldn't this spread over treasuries always be forthwith arbitraged?

No. Arbitrage only applies to combinations of securities that are "mispriced" relative to an equivalent combination of securities. For instance, if a stock is listed on two different exchanges and priced differently on them, then buying it from the exchange where it's cheaper and shorting it on the one where it's more expensive gives arbitrage. Simply being "mispriced" compared to its "actual" value doesn't allow arbitrage. Arbitrage isn't merely positive expected value, it's risk-free positive expected value.