Swedroe: High Yield Rewards Underwhelming

December 30, 2015

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.

Return (%)
Year Return
Portfolio E 10.3 12.7 0.55 -27.0

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.

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