Adapting Low-Volatility Investing to High-Yield Bonds

High-yielding, low-risk bonds are about as rare as loose $20 bills on the sidewalk. When such an opportunity arises, investors clamoring for the easy money should bid the price of bond up until its yield is driven down to a level commensurate with its risk.

Because of this competitive pressure, bond yields are one of the best indicators of bond risk. The higher the yield, the riskier the bond. Therefore, reaching for yield can be dangerous, though many do it anyway. This can push the prices of the riskiest bonds up (and their yields down), causing them to offer a less favorable risk/reward trade-off than their more lower-yielding counterparts.

The Low Volatility Anomaly While there generally is a positive relationship between risk and return, that relationship isn't linear. Securities with lower risk, as measured by sensitivity to market fluctuations--beta--or volatility, have historically offered better risk-adjusted performance than their more volatile counterparts. This relationship has been observed in both the equity and fixed-income markets. It exists because most investors prioritize return over risk-adjusted performance and are unwilling or unable to use leverage to meet their return objectives. That's understandable: After all, you can't eat risk-adjusted performance. But if you care about it, you should favor safer securities.

Low-volatility investment strategies have been successfully applied to stocks for years, but it is more challenging to apply the concept to the bond market. Bonds are more thinly traded than stocks, and stale prices can bias volatility downward, where more illiquid bonds may appear to be safer. Volatility also declines as bonds approach maturity, so past volatility may overstate a bond’s likely future volatility. And selecting bonds with low volatility would bias a portfolio toward short-duration securities. Finally, past volatility doesn’t pick up changes in risk as quickly as market prices, though the same could be said for equities.

Implementation To address these challenges, the fund ignores past volatility in its selection process. Instead, it relies on forward-looking information to target lower-risk bonds, using a measure called marginal contribution of risk. This measure is calculated as the difference between a bond's option-adjusted spread, or OAS, and the adjusted average OAS for the selection universe times the bond's spread duration. The first part of this calculation captures the market's view of the bond's current credit risk relative to the selection universe, while the spread duration captures the bond's sensitivity to changes in credit spreads.

Putting these two pieces together provides a more holistic picture of a bond’s credit risk. And it should detect deteriorating credit quality much more quickly than credit ratings or past volatility, as it incorporates OAS (that is, yield). Investors don’t wait for the credit rating agencies to say that credit quality has deteriorated to demand higher yields when the fundamentals have weakened. It is important to note that the marginal contribution of risk metrics ignores absolute duration, so the portfolio shouldn’t have a built-in bias toward short-duration bonds.

Not surprisingly, the fund does have a significant bias toward BB rated bonds, the highest rung on the high-yield bond ladder. At the end of September 2017, BB rated bonds represented 83.6% of the portfolio. By comparison, similarly rated bonds currently account for nearly 45% of

Efficient Portfolio Construction Each month, the fund's index, the S&P U.S. High Yield Low Volatility Corporate Bond Index, ranks the bonds from its liquidity-screened selection universe (the S&P U.S. High Yield Select Corporate Bond Index) on their marginal contribution of risk and selects the lowest-ranking (least-risky) 50% by count. To mitigate unnecessary turnover, existing constituents may stay in the portfolio if they rank in the lowest 60%. It then weights its holdings by market capitalization, subject to a 3% issuer cap. This weighting approach, coupled with the turnover buffer, help mitigate transaction costs. And the fund's broad reach effectively diversifies risk.

For the Watchlist HYLV was launched in February 2017, so it has a limited record and a small asset base, which can make it expensive to trade. However, as far as strategic-beta bond funds go, this is one of the more promising. It relies on forward-looking information to dial down risk while preserving diversification and taking steps to mitigate transaction costs. As an added benefit, its 0.40% expense ratio is among the lowest in the high-yield bond Morningstar Category and is on par with JNK's. This fund is worth keeping on your radar. It could become more compelling as it gains assets.

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