Are High-Yield Bonds Worth the Risk? Exploring the Trade-Offs in Your Investment Portfolio
Owning U.S. Treasury bonds are boring.
Investors looking for increased expected returns in their bond allocation typically do so in one of three ways:
Lower credit quality of bonds owned
Extending maturity to own longer dated bonds
Owning global bonds
It is true that one or a combination of all three of these strategies can increase bond returns.
But at what cost?
In investing, risk and return are used synonymously because you can’t have one without the other.
Return doesn’t come without risk.
Most commonly the approach taken to increase bond returns is through owning high-yield, non-investment grade, or junk bonds - these are bonds that have lower credit quality and in return offer higher yields.
As you might expect, the historical returns for lower quality bonds have been higher than their safer counterparts:
As you also might expect, high-yield bonds offer higher volatility:
Intermediate government bonds (GOVT):
10-year standard deviation = 4.94%
Max drawdown = -19.07%
Intermediate high-yield bonds (JNK):
10-year standard deviation = 8.71%
Max drawdown = -38.51%
The question to consider is whether high-yield bonds make sense to an investor looking to maximize returns in their investment portfolio?
To evaluate this, we’ll consider 4 portfolios with a 60% stock and 40% bond allocation with a breakdown as follows:
Portfolio A: 60% S&P 500 (VFINX) and 40% 3-7 year Treasuries (VFITX)
Portfolio B: 60% S&P 500 (VFINX), 30% 3-7 year Treasuries (VFITX), and 10% US High-yield (VWEHX)
Portfolio C: 60% S&P 500 (VFINX), 20% 3-7 year Treasuries (VFITX), and 20% US High-yield (VWEHX)
Portfolio D: 60% S&P 500 (VFINX), 40% US High-yield (VWEHX)
Evaluating each of these portfolios we see the following:
As expected, dipping into lower quality bonds offers a higher total realized return:
Over a 15-year period the portfolio of 100% high yield bonds provides higher returns by 1.13%/yr. Impressive.
But this trade-off is made with accepting more volatility, as we consider risk statistics, we see the following:
As we’d expect, the standard deviation of portfolio D offers 2.25%/yr more volatility than portfolio A with Treasury bonds and a 8.71% higher max drawdown.
The measure that’s more interesting is the historical Sharpe and Sortino ratio - which are measures of risk-adjusted returns.
Meaning - how are investors being compensated for the risk they’re taking on.
The Sharpe Ratio is a common way of measuring risk-adjusted returns through quantifying how much return per unit of risk is being taken.
The goal is to have a high Sharpe Ratio, meaning, you’re adequately being compensated for the risk that you’re taking on.
Unlike the Sharpe Ratio that measures total volatility, both upside and downside, the Sortino Ratio focuses solely on downside volatility.
The goal is to have a high Sortino Ratio, meaning, you’re getting returns with less downside risk.
Looking at each the 5-year through the 15-year Shape and Sortino ratio, Portfolio A has higher ratios for each of these categories.
So what does this tell us?
While Portfolio D, holding the high yield bonds may offer higher returns, it does so by accepting more volatility than portfolios A - C which incorporate higher quality treasuries as the bond holding (as well as a higher max drawdown).
If we consider an alternative scenario where we attempt to solve for a portfolio that has a similar Sharpe ratio, consider this Portfolio E, where we add risk in the equity markets, increasing our stock allocation to 80% and our bond allocation to 20%, we see the following:
We increase our return over every time period.
What about our risk-adjusted return?
Superior in every time series for Sharpe and Sortino.
When I looked at a 100% stock portfolio, the 5-year, 10-year, and 15-year all produced higher Sharpe & Sortino Ratios than the 60% stock 40% high-yield bond portfolio.
This finding opens the door for the potential argument that high-yield bonds are taking on unnecessary additional risk than required for higher returns.
This presents a couple considerations and takeaways:
You can take on unnecessary risk on your way to generating higher returns (which is over and above what would be required to generate a similar return).
The flaw in this argument is that this is based on historical returns - who's to say that risk-adjusted returns don’t improve looking forward?
The purpose of bonds in portfolios is to maintain purchasing power & provide a ballast for volatility from other riskier assets - if you’re going to search for yield in high-yield bonds you’re likely to receive equity-like volatility and bond-like returns.
Now I’m not saying we boycott high-yield bonds, but this does make you think twice regarding the risk-reward trade off.
So, yes, Treasuries are boring - but they might just be providing exactly what you need to provide higher risk-adjusted returns.