June 8, 2015: High Yield Bonds As An Asset Class?

Jun 9, 2015 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

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For regular SAA and TAA portfolios, the next re-balance will be on Monday, June 22, 2015. You can also find the re-balance calendar for 2014 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

High Yield Bonds As An Asset Class?

High yield bonds recently made several news. The most talked about is from several talks given by DoubleLine Capital’s Jeff Gundlach such as this presentation. Gundlach pointed out that high yield bonds, openly traded only from late 1970s, have not experienced an extended period of rising rate environment (recall interest rates peaked in 1981 and then the current secular bond bull market began). These bonds are typically issued by companies that have risky businesses or cash flow to repay interests and/or principles. 

It is understandable why some many investors are nervous about high yield bonds. Since the financial crisis in 2008, the Federal Reserve has kept interest rate extremely low (practically zero in recent years) for help companies to refinance and deleverage. It’s been a boom for many companies, sound and shaky, to latch on the ultra rate and issued junk rated bonds. They used the debt to pay off the matured debt (refinance), merge & acquire other companies or just simply to buy back their stocks (so that equity or stock holders can enjoy higher earning per share) or distribute dividends. 

Some of these companies might have solid cash flow (IBM, for example) to pay back the debt. Many, however, are doing well at the moment simply because economy is recovering. When a downturn hits, these companies will experience a hard time to pay interests or pay back principles. An old trick is to roll the mature debt to a new one. The problem is that when interest rates are high and borrowing standard is stricter, it might not be easy to do so!

It is thus prudent to question these investments. 

High Yield Bond Properties

High yield bonds have several unique properties: 

  • They are highly trendy: we have documented such a trend in some portfolios like P High Yield Bond Alpha VWEHX (or see more description on High Yield Bond Alpha) on Advanced Strategies page. Note we are not recommending this portfolio for average investors. In fact, it should be used as a reference only. 
  • The difference between their yields and that of Treasury bonds, called high yield bond spread, can be used to gauge risk appetite of fixed income investors. In general, when the spread widens, it signals higher default risk of these bonds, which in turn indicates economy trouble. 
  • They have achieved very respected returns since their invention. For example, VWEHX (Vanguard High-Yield Corporate Inv) has had an average 7.3% annual return since its inception in 1989. Furthermore, except for 2008, high yield bonds tended to have a very low volatility. 

High Yield Bond Surrogate

However, high yield bonds are nothing other than a combination of credit risk and interest risk. Recently, it has been pointed out that high yield bond index can be modeled using an stock index and a Treasury bond index. The stock index is used as a proxy to the credit risk while the Treasury index is for the interest rate. The following are the two references: 

 We used MyPlanIQ’s static portfolio feature to create a portfolio High Yield Bond Surrogate that consists of 

Fund  Percentage
NAESX (Vanguard Small Cap Index Inv) 30%
VFITX (Vanguard Interm-Term Treasury Inv) 70%

The rationale of using Small Cap Stock Index fund NAESX instead of S&P 500 is that, most high yield bond issuers (companies) are risky and have small capitalization. 

What we have is as follows: 

Portfolio Performance Comparison (as of 6/8/2015):

Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 10Yr Sharpe Since 6/21/1996 AR
High Yield Bond Surrogate 1.5% 4.0% 6.7% 7.7% 6.5% 0.91 7.3%
VWEHX (Vanguard High-Yield Corporate Inv) 2.3% 2.5% 7.3% 8.7% 6.7% 1.19 6.5%

The 10 year period comparison chart:

 

 Or for the entire period since 1996: 

See the detailed comparison >>

In general, the charts are matched reasonably well except that the surrogate portfolio has a better risk adjusted return . In our case, the portfolio has better returns but much lower maximum drawdown, even though it has higher standard deviation: 

Portfolio Performance Comparison (as of 6/8/2015, since 6/21/1996):

Fund/Portfolio Name Maximum Drawdown Standard Deviation
High Yield Bond Surrogate 12.2% 4.5%
VWEHX (Vanguard High-Yield Corporate Inv) 30.2% 6.3%

Aside from the above properties, using such a portfolio instead gives us highly liquid assets to invest. This can be especially important when risk assets are under distress, such as in 2008. 

Summary

We offer several observations/suggestions: 

  • There is no need to have a separate asset class for high yield bond in asset allocation. This assertion is also supported by David Swensen, Yale endowment manager. He dislikes this asset class as it does not offer any better risk adjusted return than using other pure stock and Treasury asset classes. See  Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. 
  • As we are at the tail end of the secular declining rate (bond bull market), even though it is still quite uncertain when and how rates are raised, it is prudent to be careful on high yield bonds. In fact, based on the above, it does not harm to abandon this asset class altogether. 
  • It is also better off to leave the investments in high yield bonds to a good total return bond fund manager. Again, going forward, we believe the best approach in fixed income investing is to utilize our total return bond fund portfolios (see this page). The dynamic rotation among good total return bond funds will also ensure that our investments are not trapped to a bad performing fund for too long to incur large loss. 

Market Overview

Summer began with further weakness across all asset classes. Among them, only US stocks are still hanging above some ‘safer’ bond assets. As the moment, we will see how markets unfold and then follow their trends for tactical purpose. For strategic asset allocation, it is a good time to review your overall risk exposure to adjust to a level that you are comfortable with. 

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now.  However, recognizing our deficiency to predict the markets, we will stay on course. 

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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