Swedroe: High Yield Rewards Underwhelming

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.

As we might expect, given that the high-yield index outperformed five-year Treasury bonds by 1.8 percentage points per year over this period, Portfolio D posted the highest return of the four portfolios. However, it did not win by a wide margin, beating Portfolio A by about 0.5 percentage points per year and Portfolios B and C by just 0.3 percentage points and 0.2 percentage points, respectively.

Furthermore, the price for the slightly higher returns in Portfolio D was much higher volatility than any of the alternative portfolios. In addition, the worst calendar-year return was much lower for Portfolio D than any of the others. This is an especially important negative for investors in the withdrawal phase.

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

There are two reasons volatility grew and the Sharpe ratio declined for the portfolios that allocated their fixed income to high-yield bonds. First, high-yield bonds are more volatile than high-quality bonds. The high-yield bond index had an annualized standard deviation of 9.7% per year while the Treasury index had an annualized standard deviation of 5.4% per year.

Second, the high-yield bonds had a higher correlation to the S&P 500. Over this time period, the quarterly correlation of the Barclays U.S. Corporate High Yield Index to the S&P 500 Index was 0.62, while five-year U.S. Treasury notes had a quarterly correlation to the S&P 500 of -0.19.

A Different Route To Returns

If you need more risk (return) in your portfolio, you can construct a portfolio that has similar risk and return characteristics to Portfolio D by increasing your allocation to equities. Portfolio E, shown below, is allocated 80% to the S&P 500 and 20% to five-year Treasury notes.

Portfolio E looks very similar to Portfolio D from a risk and return perspective. Portfolio E, however, has a few advantages over Portfolio D that do not show up in the returns data. First, investing in a high-yield bond strategy is more expensive than investing in Treasury notes. The index doesn't take into account transaction costs or manager costs.

Second, investing in an 80% equity and 20% Treasury note portfolio is more tax efficient than investing in a 60% equity and 40% high-yield bond portfolio. The returns from equities are taxed at capital gains rates, while the returns from high-yield bonds are taxed at ordinary income rates.

David Swensen, chief investment officer of the Yale Endowment, summed it up best when he said: "Well-informed investors avoid the no-win consequences of high-yield fixed-income investing."

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.