Swedroe: Beware The Promise Of Junk Debt

August 18, 2014

As we might expect, given VWEHX’s 1.4 percentage point outperformance relative to five-year Treasurys, Portfolio D had the highest return of the four portfolios. However, its outperformance was minimal, beating out Portfolio A by 0.2 percentage points per year and Portfolios B and C by just 0.1 percentage points per year. In addition, the price for slightly higher returns in Portfolio D has been much higher volatility than any of the alternative portfolios.

Portfolio A, without any allocation to VWEHX, had the highest Sharpe ratio of the four portfolios, making it the most efficient choice. In fact, as the allocation in our portfolios to high-yield bonds rose, the Sharpe ratio decreased.

It is important to note that we end this period of analysis with high-yield spreads at historically low levels. Despite this, the addition of high-yield bonds had a negative impact on portfolio efficiency.

I mention this to point out that, if we examined a period ending with a poor run for high-yield bonds, the results would look even worse. The reason for this poor performance is that the risks of investing in high-yield bonds don’t mix well with equity risks.

From July 1983 to June 2014, the annual correlation of the Barclays Capital U.S. Corporate High Yield Index to the S&P 500 was 0.58. Over this same period, the annual correlation of five-year Treasurys to the S&P 500 was 0.12. Importantly, in 2008, while the correlation of high-yield bonds to stocks was rising (at just the wrong time), the correlation of five-year Treasurys to stocks was turning highly negative (at just the right time).

Historically, the additional risk of high-yield bonds hasn’t been well-rewarded. And today, with credit spreads at historically low levels, the outlook doesn’t look promising. For the best risk-adjusted returns, investors are better off sticking with high-quality bonds.

If you need more risk (return) in your portfolio, you’re better off taking that risk with stocks, where you can diversify those risks more effectively and earn returns in a more tax-efficient manner.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.



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