Swedroe: Beware The Promise Of Junk Debt

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.

*Measure of risk-adjusted returns

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.