High Yield Bonds Are Good Alternatives For Aggressive Fixed Income Investors

Jul 18, 2023 | Asset-Allocation, Bonds, ETFs, Feature, Income, Investments, Newsletter, Stocks

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Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Monday August 1, 2023. 

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High Yield Bonds Are Good Alternatives For Aggressive Fixed Income Investors

High yield bonds, also nicknamed as “junk bonds”, are a unique category of bonds often perceived differently by stock investors, who may find them unexciting and don’t offer high enough returns, and fixed income investors, who may tend to avoid them because of their high volatility. In this newsletter, we delve into their historical significance and examine why they present a compelling option as an alternative asset class for fixed income investors, particularly those with a more adventurous appetite seeking greater returns.

Some background of high yield bonds

In the late 1970s, Michael Milken, a financier working for Drexel Burnham Lambert,  pioneered the concept of “junk bonds,” a term that initially carried a negative connotation. However, Milken saw potential in the high-risk, high-yield bonds issued by companies with lower credit ratings. He believed that these firms, despite their riskier profiles, had strong underlying fundamentals that could justify their debt offerings. By creating a market for these bonds, Milken unlocked a new source of financing for companies that would have otherwise struggled to secure capital through traditional means. His vision and ability to analyze the creditworthiness of these firms reshaped the financial landscape, allowing them to raise funds at a time when they were shunned by conventional lenders. Although controversial, Milken’s invention of junk bonds proved to be a catalyst for economic growth and played a pivotal role in shaping modern finance, leaving a lasting legacy in the world of high finance.

Milken further believed that the high yields offered by these “junk bonds” more than compensated for their inherent risk. In his view, when factoring in default rates and the subsequent recovery rates, investors in these bonds stood to achieve higher returns compared to those offered by investment-grade bonds.

Historical high yield bond yields, default rates and recovery rates

To understand returns of a debt or a bond, one should at least understand the following concepts in layman’s terms:

  • Yield: also called interest, can be roughly understood as annual percentage payout
  • Default rate: when a debt or a bond stops paying interest or principal to its creditors, this is called default. When a default event occurs, creditors will take action to recover all or some of their principals. 
  • Recovery rate: the percentage of principal to be recovered is called recovery rate. For example, if the total amount debt (principal) of a bond security is $1 million dollar, and the recovery rate is 60%, that would mean creditors will get $600,000 back. Or simply put, creditors would get 60 cents back on the dollar. 

Historically, the high yield bonds default rate is around 3.6% annually (based on Fitch). The average recovery rate is around 40%. To calculate final yield of a bond, one can use the following formula:

Final Yield = Yield – Yield* Default Rate * (1-Recovery Rate)

So on average, that means investors will only lose 3.6%*(1-40%) or 2.16% of yield annually. 

PIMCO has written an excellent article on high yield bond investments. In the article, it stated that ‘high yield bond investments have historically offered similar returns to equity markets, but with lower volatility.’ 

It further shows the following high yield bond average returns up to 2017 when the article was written:

So it’s very telling that high yield bonds shouldn’t be overlooked by stock investors who are looking for high returns. 

Past returns and risk of high yield bond funds

Let’s take a look at the latest total returns (dividend or interest reinvested) from a few high yield bond index funds: 

Fund Performance Comparison (as of 7/17/2023)
Ticker/Portfolio Name 1Yr AR 3Yr AR 5Yr AR 10Yr AR 10Yr Sharpe 15Yr AR
HYG (iShares iBoxx $ High Yield Corporate Bd) 12.9% 4.8% 4.3% 4.1% 0.39 5.6%
JNK (SPDR Barclays High Yield Bond ETF) 15.0% 5.4% 4.6% 4.1% 0.39 5.6%
HYD (Market Vectors® High-Yield Municipal ETF) 4.6% 1.9% 1.5% 3.6% 0.22  
VWEHX (Vanguard High-Yield Corporate Inv) 13.5% 4.3% 4.7% 4.8% 0.74 6.3%
VBMFX (Vanguard Total Bond Market Index Inv) -0.3% -4.1% 0.7% 1.4% 0.14 2.6%
SPY (SPDR S&P 500 ETF) 22.4% 14.3% 12.1% 12.6% 0.67 11.2%

*: NOT annualized

Detailed links for more data such as maximum drawdown

In the above table, we compare the two popular high yield bond index ETFs (HYG and JNK), Vanguard high yield bond fund VWEHX, Vanguard total bond index fund (VBMFX, similar to ETF BND). We also include municipal high yield bond fund (HYD) and S&P 500 stock index ETF SPY. 

Some observations:

  • The two high yield bond ETFs HYG and JNK have virtually the same 15 year returns. 
  • Both ETFs have lagged VWEHX, indicating the bond mutual fund still has better edge over ETFs.
  • All of the high yield bond funds have done much better than VBMFX, the total bond index fund. In fact, they have much higher Sharpe ratios than VBMFX for the past 10 years. 
  • On the other hand, the high yield bond funds have underperfomed SPY by some big margins. However, if we extend our comparison since 2000, we see the following 

So since 2000, stocks and high yield bonds actually have similar returns but VWEHX has much lower maximum drawdown. 

Of course, if we extend from 1993, SPY (stocks) still has done much better: 

Mitigation of high yield bond risk

Despite high yield bonds often delivering better returns compared to general bonds, including investment-grade corporate bonds, they also come with heightened volatility, particularly during periods of financial market distress. For instance, in 2008, both HYG and VWEHX experienced maximum drawdowns of 34% and 32%, respectively, compared to 5.4% in the same year or 17% in 2022 for Vanguard total bond index fund VBMFX, which was one of the highest drawdowns since its inception in 1987.

However, there are strategies to mitigate this risk. One approach involves diversification by allocating a limited portion of capital to high yield bonds, limiting their share to, for instance, 20% in a fixed income portfolio. This can boost long-term fixed income returns while maintaining an acceptable risk level.

Another method is to utilize target maturity high yield bond funds. Traditional high yield bond funds like HYG or JNK hold bonds with varying maturities, resulting in fluctuating fund values depending on market conditions at any given time. On the other hand, target maturity funds focus on bonds that are expected to mature by a specified time, providing a more stable investment approach. For example, the iShares iBonds 2025 Term High Yield Bond ETF (IBHE) holds 188 high yield bonds maturing by December 2025. Investing in such funds allows one to hold them until maturity without much concern about interim price movements. Moreover, building a bond fund ladder using these target maturity funds can help mitigate interim interest rate risk and some credit risk. We will discuss bond fund ladders in some future newsletters. 

In conclusion, both fixed income and equity investors should not dismiss high yield bonds outright, especially if they have sufficient experience and seek higher returns. By employing appropriate strategies and prudent allocation, high yield bonds can be a valuable addition to an investment portfolio.

Market overview

The second-quarter earnings reporting season has begun, and thus far, only a small fraction of S&P 500 companies (approximately 6%) have reported their results as of last Friday. The outcomes are in line with expectations, as per Factset data, indicating a blended earnings growth of -7.1%, almost mirroring the anticipated -7% figure as of June 30, 2023.

On the inflation front, the latest Consumer Price Index (CPI) report showed a sustained downward trajectory. Consequently, many investors now hold the belief that the period of surging inflation has come to an end. This optimistic outlook has propelled stock market prices higher, fostering upward trends in risk assets.

As always, we call for staying the course which is guided by the well defined and sound strategic and tactical strategies:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or preferably much longer given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation has dropped and now valuation is becoming less hostile. However, it is still not cheap by historical standard. For the moment, we believe it’s prudent to be extra cautious. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that 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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