Investors have now been faced with a long period of very low yields on high-quality bonds. As a result, and as a consequence of the Federal Reserve's easy monetary policy, many investors have chosen to pursue higher yields by taking credit risk. This has occurred despite historical evidence that only a very small default premium has existed. What's more, this premium has been small even before considering transaction costs.
My colleague and co-author, Kevin Grogan, recently took another look at high-yield bonds and shows once again that investors have not been well rewarded.
Key Takeaways From A Faltering Fund
He starts by observing that, earlier this month, the Third Avenue Focused Credit Fund (FCF) blocked investors from pulling their money so the holdings could be liquidated. The fund put its remaining assets in a liquidating trust that will seek to sell them over time.
In a statement, Third Avenue Management's now former Chief Executive Officer, David Barse, said, "We believe that, with time, FCF would have been able to realize investment returns in the normal course. Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable" for the fund "to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders."
There are several important lessons from this story, the first of which is how important liquidity can be. Some investors are all too willing to pick up a liquidity premium without first planning sufficiently for the risk that it dries up. When liquidity dries up, as it did recently for high-yield bonds and for many asset classes during the financial crisis, market impact costs can jump dramatically. This is easy to say in hindsight, but a fund that invests in asset classes with a history of periods of low liquidity (like junk bonds) should never have promised daily liquidity to begin with.
The second lesson is that it generally does not make sense for most investors to include high-yield bonds in their portfolio. From January 1984 through September 2015, the Barclays U.S. Corporate High Yield Index returned 9.0% per year. By comparison, the Barclays Credit Bond Index Intermediate returned 7.5% per year and five-year Treasury bonds returned 7.2% per year over the same period.
While the high-yield index had higher returns, looking at asset classes in isolation isn't the right way to analyze performance. Instead, consider looking at how the investment impacts the risk and return of the entire portfolio. With this in mind, we'll examine how adding high-yield bonds to a portfolio affected it over this period of time.
A Portfolio Comparison
We will now compare four portfolios during the January 1984 through September 2015 time period, each with an allocation of 60% to the S&P 500 Index.
Portfolio A will invest its fixed income in five-year Treasury bonds. Portfolio B will allocate its fixed income 30% to five-year Treasury bonds and 10% to the Barclays U.S. Corporate High Yield Index. Portfolio C will allocate its fixed income 20% to five-year Treasury bonds and 20% to the Barclays U.S. Corporate High Yield Index. Portfolio D will invest its fixed income in the Barclays U.S. Corporate High Yield Index.
| Annualized Return (%) |
Annualized Standard Deviation (%) |
Annualized Sharpe Ratio |
Worst Calendar Year Return (%) |
|
| Portfolio A | 9.7 | 9.5 | 0.64 | -17.0 |
| Portfolio B | 9.9 | 10.1 | 0.62 | -20.9 |
| Portfolio C | 10.0 | 10.9 | 0.60 | -24.8 |
| Portfolio D | 10.2 | 12.5 | 0.55 | -32.7 |
