High-Yield Bonds' Effect on Portfolios

As I have frequently mentioned, you should never look at an asset class or investment in isolation when considering it for your portfolio. On Wednesday, we looked at how GNMAs have impacted portfolios when added. Today, we'll look at high-yield bonds.

Looking only at returns (while not considering risk), the Vanguard High Yield Corporate Fund looks like a good investment compared to its benchmarks. (Please note that the Vanguard fund's annualized return is measured from its inception on Dec. 27, 1978 through 2009. The benchmarks' annualized returns are measured from 1979 through 2009.)

Vanguard High Yield Corporate -- 8.72 percent
Five-Year Treasury Notes -- 8.23 percent
Gov't Bond Index (1-30 Years) -- 8.45 percent
Barclays Capital Credit Bond Index Intermediate -- 8.70 percent

Using Morningstar's database, which goes back 20 years, we can look at how the addition of the Vanguard fund affects portfolios. During this period (1990-2009), the high-yield fund returned 7.4 percent with a standard deviation of 12.9 percent and five-year Treasuries returned 6.65 percent with a standard deviation of just 6.2 percent.

As we did on Wednesday, let's look at two portfolios that are rebalanced annually:

Portfolio A has a 60 percent allocation to the S&P 500 Index and a 40 percent allocation to the Vanguard fund. This portfolio returned 8.1 percent per year with a standard deviation of 16.1 percent.
Portfolio B has a 60 percent allocation to the S&P 500 and a 40 percent allocation to five-year Treasuries. This portfolio returned 8.2 percent but did so with a standard deviation of just 11.6 percent.

Thus, while the high-yield fund produced higher returns during this period, its addition to the portfolio not only produced a lower return, but it resulted in a portfolio with almost 40 percent greater volatility. Portfolio B was a much more efficient one. Note that the quarterly correlation of the high-yield fund to the S&P 500 was 0.62, while the correlation of the five-year Treasury to the S&P 500 was -0.28, making the five-year Treasury note a much more effective diversifier of the risks of equities.

As we have seen, it's important to consider the effect of adding an investment or asset class on your entire portfolio before adding it, no matter how good it may look beforehand.

Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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