I got an e-mail this past week noting that Vanguard would be closing its high-yield corporate bond fund to new investors “effectively immediately” and that the fund had received “approximately $2 billion” of flows over the past six months. While growth of Vanguard’s assets under management is almost always a good thing, a fund shuttering its doors to new flows makes one wonder just how frothy credit markets have become. Let’s take a step back, though, and look at high-yield fixed income as an asset class. I find that many investors simply don’t understand what returns high-yield bonds have historically generated or just how closely correlated they are with the equity markets.
Over the period 1970–2009, which is the longest data series available, Moody’s reports that 21 percent of high-yield corporate bonds default within a typical five-year period. This means that if you started with a portfolio of 100 high-yield corporate bonds, on average 21 of those would have defaulted after a five-year holding period. What does this mean from the investor’s point of view? It means that your return on investment will be something substantially less than the yield of your portfolio of high-yield bonds.
We can gauge just how much “slippage” there has been using data from Barclays Capital. Barclay’s reports that the yield advantage of high-yield corporate bonds compared to Treasury bonds of comparable maturity has been about 5.3 percent over the period January 1994–March 2012. This means that if Treasury bonds yielded 5 percent on average over this period that high-yield bonds yielded about 10.3 percent on average. Yet, the return advantage of high-yield corporate bonds relative to Treasury bonds has only been about 2 percent per year. So, investors lost roughly 60 percent of the yield advantage to defaults.
Further, we also see that high-yield bonds have been helped by outstanding recent performance relative to Treasuries. For the period 2009–2011, high-yield bonds outperformed comparable Treasuries by a whopping 18.5 percent per year, making up for the significant long-term underperformance of the previous 15 years, when they underperformed Treasuries by 2.3 percent per year.
From a correlation point of view, high-yield corporate bonds tend to be closely related to the stock market. This means that if you add high-yield corporate bonds to your portfolio and treat them like your other bonds, you’ll likely be in for a big surprise when stock markets head south. As one example of this, high-yield corporate bonds underperformed Treasury bonds by about 40 percent over the period January 2007–February 2009, which encompasses the worst part of the financial crisis and a terrible period for the stock market. Over the third quarter of 2011 when the Eurozone crisis hit one of many boiling points, high-yield corporate bonds underperformed Treasury bonds by about 7 percent.
Another basic question we can examine is whether it’s possible to create a portfolio that performs similar to or better than high-yield corporate bonds using stocks and Treasury bonds. Such a portfolio would also be more tax efficient than high-yield corporate bonds because a large portion of its return would be in the form of capital gains. (Also, Treasury bonds aren’t currently taxable at the state level, while high-yield corporate bonds generally are). Using the January 1994–March 2012 period from above, we find that a portfolio with about 40 percent in small-cap value stocks and 60 percent in high-quality bonds would have performed very similarly to high-yield bonds, underperforming by about 1 percent per year. However, the underperformance likely would have been offset by the relative tax efficiencies of the stock and Treasury portfolio compared to the high-yield corporate bond portfolio.
So in summary we find that a substantial fraction of high-yield corporate bonds ultimately default and consequently that the returns of high-yield corporate bonds compared to Treasury bonds have been substantially less than the yield advantage. Further, a portfolio of stocks and bonds — particularly on an after-tax basis — should do a decent job of tracking the returns of high-yield corporate bonds over the longer term.
Random Links and Commentary of the Week
Some weekend reading for Ozzie Guillen. I came across this absolutely great story in The New Yorker from David Grann (author of “The Lost City of Z” which is great as well) about William Morgan, an American who took part in the Cuban Revolution.
I also saw that Wes Anderson is coming out with a new movie “Moonrise Kingdom” which I can’t wait to see. I’m a huge fan of most of his other movies (save “The Life Aquatic with Steve Zissou”).
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