Why junk bonds aren't a good portfolio fit

(MoneyWatch) On May 24, Vanguard announced that it was closing its high-yield corporate fund (VWEHX) to new investors. The reasoning behind the closure was strong cash flows into the fund. Vanguard CEO Bill McNabb said the following:

"In this prolonged low-rate environment, we continue to see investors turn to high-yielding alternatives - including money market holders moving to bond funds, U.S. Treasury bond holders moving to high-yield corporate funds, and bond fund holders moving to dividend-paying stock funds. And we've cautioned investors accordingly about reaching for yield. The flows into the High-Yield Corporate Fund have been particularly acute, so we're taking these proactive steps to preserve the ability of the advisor to manage the fund effectively and protect the interests of existing shareholders."

Today, I will look at whether it makes sense to add high-yield bonds to a portfolio. From inception (Dec. 27, 1978) through 2011, VWEHX returned 8.8 percent per year. The following are the annualized returns of two alternative fixed income indexes over the same period:

While the Vanguard fund carried much higher yields than either of these two indexes, the fund's realized returns were comparable to the returns of the Barclays index (which has less credit risk) and the returns of an index with no credit risk.

However, as we have discussed, looking at asset classes or investments in isolation isn't sufficient. Investors should look at how their addition impacts the risk and return of the entire portfolio. Looking at things in the whole is the only right way to view things. Using Morningstar's database, which goes back 20 years, we can do just that.

During this period (March May 1992-April 2012), VWEHX returned 7.4 percent with a standard deviation of 8.3 percent, and five-year Treasuries returned 6.3 percent with a standard deviation of just 4.5 percent.

We will now compare two portfolios, each with an allocation of 60 percent to the S&P 500 Index. Portfolio A will allocate its 40 percent fixed income allocation to VWEHX, while Portfolio B invests in five-year Treasuries. Portfolios are rebalanced annually.

Thus, while VWEHX produced higher returns during this period, its addition to the portfolio not only didn't result in higher portfolio returns, but it resulted in a portfolio with greater volatility.

Portfolio B was a much more efficient one. Note that the quarterly correlation of VWEHX to the S&P 500 was 0.67, while the correlation of the five-year Treasury to the S&P 500 was -0.26, making the five-year Treasury a more effective diversifier of the risks of stocks.

To summarize, investors in VWEHX haven't been rewarded with greater portfolio returns, let alone greater risk-adjusted portfolio returns.

Image courtesy of Flickr user 401(K) 2012.

[EdChao]

Larry,

I've found the backtesting examples in this story and your books really helpful in seeing the concept of asset correlation at work. I'd like to be able to run this kind of analysis on my own asset allocation and wanted to ask if there's a tool that you recommend for these simulations?

Ed

[FractalFin]

Larry, also, forgot to ask how would you position a Fallen Angels fund in a portfolio? Would you consider a percentage of the fund as being part of your equity similar in percentages to an investment grade bond fund?

Thanks again for all that you do for individual investment community.

Peter

[LarryswedroeCBS]

Peter
It depends on the credit rating. A just below investment grade would be say 20-25% equity but a CCC would be say 50% equity.

Best Larry

[FractalFin]

Larry, you mentioned Fallen Angels. Have you looked closely at the composition of Market Vectors Fallen Angel HY Bond ETF? Does it seem to really behave with the same risk-adjusted returns as the Fall Angel group?

Thanks for the great info.

Peter

[LarryswedroeCBS]

Have not looked at it. But I personally would not invest because I view the role of FI is to dampen the risk of the overall portfolio to acceptable level. I prefer taking the risks on the equity side and high yield creates a location problem as would have to hold in IRA and that means taking equity risk in the wrong location

Best wishes
Larry

[maynardGkeynes]

Larry, the thing with VWEHX is that it was never really been that risky. It's holdings have always been pretty conservative and safe for a HY fund. So you weren't taking that much risk, and in turn, you weren't getting paid that much. I'm not sure it really makes the case against HY, but more about the way Vanguard managed it.

[LarryswedroeCBS]

VAnguard is what is called high yield, as opposed to Junk, which is CCC. But they are only fund that has been around long time. The same analysis has been done on junk and same results. The only high yield that has delivered better risk adjusted returns are what are called FALLEN ANGELS--once investment grade that gets downgraded. What happens here is you pick up a huge liquidity premium as many institutional investors must sell (by their charters), all at basically the same time, and that drives prices way down--and now you also get a liquidity premium.

You can find the more detailed analysis in my book on Alternative investments, chapter on high yield bonds

Best wishes
Larry

[R9619]

Thanks Larry - helpful as always. That said, I wonder whether:

- the strong historical performance of US government bonds actually makes them less safe going forward.

- In light of our staggering government debt and Congress's seeming inability to tackle the tough issues underlying it, the low yields US bonds offer is truly a reflection of how safe these investments are or more a reflection of the need by certain large holders (e.g., foreign governments, pension funds, etc.) to hold them since, for now, there are limited substitutes.

Best,
Ross

[LarryswedroeCBS]

Ross
I would add this: US treasuries have benefited from two things, not only a flight to safety but also a flight to liquidity. You can see this in TIPS yields which have the same credit risk and avoid unexpected inflation risk but have higher expected returns for the same maturities (so negative risk premium for unexpected inflation)

Possible high yield will do relatively better inside a portfolio than Treasuries going forward because of that, but that is still the wrong way to look at it. Better to look at staying in Treasuries and adding some more equity risk, value tilting to get the same expected return but in more tax efficient and lower cost way (and more diversified).

Hope that helps

Larry