Swedroe: Beware The Promise Of Junk Debt

August 18, 2014

In the quest for yield, there may be better options than high-yield debt. 

Until the recent sell-off toward the end of July, yields on high-yield bonds had been hitting record lows. At the end of June 2014, the yield on five-year bonds rated BB—the credit rating just below investment grade—was only 4.3 percent, or about 2.7 percentage points higher than the yield on five-year Treasurys. That puts the yield spread at levels not seen since before the 2008 financial crisis began.

This all matters because with the yields on safe bond investments at low levels, investors are chasing yield wherever they can find it—not just in high-yield bonds, but in other risky investments, such as dividend-paying stocks and REITs.

My colleague and co-author Kevin Grogan takes a look at whether it makes sense to add high-yield bonds to a portfolio. From its inception in January 1979 through June 2014, Vanguard’s High Yield Corporate Fund (VWEHX) returned 8.8 percent per year. By comparison, the Barclays Credit Bond Index Intermediate returned 8.3 percent per year over the same period.

While the Vanguard fund carried a higher yield than the Barclays index—sometimes hundreds of basis points higher—the fund’s realized returns were just 0.5 percentage points per year larger than that of the Barclays Index.

However, looking at asset classes or individual investments in isolation isn’t the right way to analyze performance. Instead, you should look at how the investment impacts the risk and return of the entire portfolio. With that in mind, we’ll examine how adding high-yield bonds to a portfolio impacted it over a 20-year period.

During this period, July 1994 to June 2014, VWEHX returned 7.1 percent per year, outperforming the 5.7 percent return on five-year Treasurys by 1.4 percentage points per year. However, the standard deviation of VWEHX was 6.1 percent versus just 4.3 percent for five-year Treasurys.

We will now compare four portfolios, each with an allocation of 60 percent to the S&P 500 Index. Portfolio A will invest its fixed income in five-year Treasurys. Portfolio B will allocate its fixed income 30 percent to five-year Treasurys and 10 percent to VWEHX. Portfolio C will allocate its fixed income 20 percent to five-year Treasurys and 20 percent to VWEHX. Portfolio D will invest its fixed income in VWEHX.

Return
(%)
Standard 
Deviation
(%)
Sharpe
Ratio*
Portfolio A 8.8 10.0 0.647
Portfolio B 8.9 10.6 0.624
Portfolio C 8.9 11.2 0.600
Portfolio D 9.0 12.5 0.551

 

 

 

 

 

*Measure of risk-adjusted returns

 

 

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