Rekenthaler Report

Are High-Yield Bonds Necessary?

John Rekenthaler

Possible Substitutes
Last month, I wrote that investors can substitute for high-yield bonds by owning a mix of 1) investment-grade bonds and 2) large-value stocks. As that statement was a side point, I did not provide evidence for the claim. Today's article does just that. 

Practically speaking, high-yield bonds are hybrid securities. As with investment-grade bonds, high-yield bonds pay income while also offering some default protection (albeit not as much as investment-grade bonds). However, they resemble stocks in being economically sensitive. Companies that issue high-yield bonds are generally not the healthiest. (If they were otherwise, their bonds wouldn't yield so much!) They are particularly vulnerable to recessions.

That last sentence also describes large-value stocks, which tend to be cheap because they are economically sensitive. (If they were otherwise, their stocks wouldn't cost so little!) Therefore, high-yield bonds tend to come from companies that Morningstar categorizes as "large value." The sector exposures between the high-yield marketplace and large-value indexes are much the same, too. Manufacturing, energy, and financial concerns account for 50% of high-yield bonds--and for 45% of  Vanguard Value Index's (VVIAX) stock weighting.

It would seem, therefore, that combining the two main attributes of high-yield bonds--their fixed-income characteristics and their kinship with the stock market's "big uglies"--should create a blend that performs similarly. Such has long been my belief, and such was so when I initially examined the results.

By the Numbers
But Excel outdoes eyeballs. For this column, I gathered 15 years' worth of average monthly total returns for three mutual fund categories: 1) high-yield bond, 2) intermediate-core bond, and 3) large-value stock. I then concocted a 50/50 blend of the latter two categories, rebalanced monthly, and compared its performance with that of the original.

Pretty close. The annualized gain for high-yield bond funds was 5.8%; meanwhile, the blend portfolio registered 5.4%. Risk was more similar yet, with the high-yield bond funds showing a monthly standard deviation of 2.3 percentage points, while the blend strategy was a shade lower, at 2.2 points. (Monthly standard deviation figures aren't intuitive, but in this instance they need not be, because all that matters is that the two numbers are almost identical.)

I then tinkered with the mix, to see if something other than an even split between the investment-grade bonds and large-value stocks would improve the match. Nothing happening. As it turned out, the simplest and dumbest assumption--the 1/n strategy, as the professors say--provided the best fit. Ain't life grand?

The benefit of using 15 years' worth of data, rather than a decade's worth, is that the longer time period includes 2008. However, the benefit is also the drawback. Investment performance during the financial crisis was so extreme that, potentially, it could drive the conclusion. It may have been, for example, that one strategy consistently lagged the other through the 15-year period, except during 2008. In such a case, the two investment approaches would have landed in the same place, but through very different paths.

The Long-Term View
Not so: The second look doesn't much change the first impression. In fact, it strengthens it. When the measurement period excludes 2008, total returns for the two strategies converge, with high-yield bonds recording a 7.9% annualized gain and the blend portfolio at 7.8%. (The results were even tighter than they appear, as the high-yield figure is rounded up, while the blend portfolio is rounded down.) Standard deviations continue to be roughly comparable, with the blend strategy at 1.9 percentage points and high-yield bonds at 1.7.

Six of one, half a dozen of the other. For both time periods, high-yield bond funds outdid the combination strategy, but only by the slenderest of margins. In practical terms, the two approaches appear to be interchangeable. One could allocate specifically to high-yield bonds, or arrive at the same place by holding more investment-grade bonds and value stocks. Either path is acceptable.

So no, high-yield bonds are not strictly necessary. On the other hand, neither are they useless. I have never spoken kindly of a market-neutral fund, or a leveraged index fund, or a 130/30 fund (now extinct, but they were once a thing), and likely never will. But there's nothing wrong with high-yield bond funds. They can help a portfolio. They are not, however, indispensable.

Short-Term Considerations
One further item should be noted. Most months, high-yield bond funds are reliably obedient, posting returns that land midway between those of the other two categories. In the study's initial month of June 2004, for example, large-value funds rose 2.44% and intermediate-core bond funds gained 0.46%, for an average of 1.45%. High-yield bond funds were up 1.36%, thereby fulfilling expectations. Sometimes, though, the usual pattern breaks.

The most notable instance was in late 2008 and early 2009, when high-yield bond funds fell further during the crash than the simple 50/50 model predicted, and then rebounded more sharply. (In second-quarter 2009, high-yield bond funds appreciated by 19%, which matched the S&P 500's return and exceeded that of the large-value indexes.) In autumn 2008, the high-yield marketplace failed to function properly, which artificially depressed bond prices. When the marketplace recovered, high-yield bonds enjoyed a one-time boost.

Conversely, when stocks were pounded this past December, such that large-value funds lost almost 10% for the month, high-yield bond funds were relatively quiet. Even though intermediate-core bond funds gained only a modest 1.3%, meaning that they didn't provide great support for the other half of high-yield bond funds' performance, the high-yield category fell only 2%. The 50/50 model forecast that loss to be twice as high.

These occasional oddities don't justify owning both versions of high-yield bonds. Either hold the original, or the substitute of the blend portfolio. The extra diversification that accrues from owning high-yield bonds in two ways is minute. But it does suggest the occasional trade. At times, high-yield bonds may be underpriced when compared with their substitute (or vice versa). That could be a profitable exchange, albeit probably for investment professionals rather than everyday investors.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.