Resisting the Urge to "Reach for Yield"

2012-12-06

by: Eric Nelson, CFA

November’s Factors In Focus newsletter, "Don't Bail on High-Quality Bonds", looked at the superiority of the safest bonds in offsetting stock market declines and reducing the overall risk of balanced portfolios.  But high-quality bonds, due to their lower risk, also have lower returns when compared to Corporate and High-Yield "Junk" Bonds.  However, with interest rates today at record-low levels, the urge to “reach for yield” with these higher-risk bonds is tempting.  

 

So is there really a benefit to sticking with high-quality bonds even after we account for their lower long-term returns?  Absolutely.  A closer look at various types of bonds by themselves and within the context of balanced portfolios reveals there is no benefit to taking risk with bonds.

 

Let’s start with the basics.  Investors have three primary options for credit quality in their fixed income portfolios: Government Bonds, Investment-Grade Corporate Bonds, and High-Yield “Junk” Bonds.  Table 1A and 1B show that while Investment Grade Corporate and High-Yield “Junk” Bonds have had higher returns than Government Bonds, they’ve also had higher risk as measured by standard deviation.  But if higher risk is called for, an alternative approach would be to maitain the safer bonds, and instead reduce their overall allocation and add small amounts to a diversified stock portfolio.  This offers the opportunity to achieve higher returns for a given level of risk.

 

TABLE 1A

Index/Portfolio

Annualized Return (1973-10/2012)

Standard Deviation (Risk)

100% Barclays Government Bond Index

+7.9%

5.2

100% Barclays Corporate Bond Index

+8.4%

7.2

35/65 Balanced Stock and Bond Index

+10.2%

7.3

1973 = inception of Barclays Bond Index data.  35/65 Balanced Stock and Bond Index = 7% S&P 500, 10.5% DFA US Large Value Index, 17.5% DFA US Targeted Value Index, 65% Barclays Government Bond Index rebalanced annually.

 

Table 1A shows that since 1973, a portfolio of Corporate Bonds has earned about 0.5% more than safer Government Bonds at the expense of 2% more risk.  But bonds aren’t our only option for increasing expected returns and risk.  Adding small amounts of a diversified stock allocation to low-risk bonds accomplished the same task more efficiently.  Over this period, adding 35% in Stocks to the Government Bond Index incurred the same level or risk as 100% in Corporate Bonds (7.3 vs. 7.2), but produced almost 2% higher returns.

 

TABLE 1B

Index/Portfolio

Annualized Return (1984-10/2012)

Standard Deviation (Risk)

100% Barclays Government Bond Index

+7.8%

4.7

100% Barclays High-Yield Bond Index

+9.6%

8.8

50/50 Balanced Stock and Bond Index

+10.5%

8.8

1984 = inception of Barclays High-Yield Bond Index data.  50/50 Balanced Stock and Bond Index = 10% S&P 500, 15% DFA US Large Value Index, 25% DFA US Targeted Value Index, 50% Barclays Government Bond Index rebalanced annually.

 

The history on High-Yield Bonds only dates back to 1984, but Table 1B reveals the record is the same.  While outpacing Government Bonds by almost 2%, their risk was approximately double (8.8 vs. 4.7).  Adding as much as 50% in stocks to the Government Bond Index also raised the overall risk up to the level of High-Yield Bonds, but earned almost 1% more per year in returns.

 

So on a stand-alone basis, the evidence is clear: bond risk is a bad bet.

 

But few portfolios are 100% in bonds, so this example may not apply to most investors.  Instead, many who hold bonds do so in conjunction with a diversified stock portfolio—such as a traditional 60% stock, 40% bond combination.  So in the case of a portfolio dominated by stocks, does adding higher-risk fixed income begin to make sense?  Again, we find the answer is no.

 

Table 2A and 2B look at 60/40 combinations of balanced portfolios while controlling for risk.

 

TABLE 2A

Stock/Bond Combinations

Annualized Return (1973-10/2012)

Standard Deviation (Risk)

Average Loss

60/40 with Barclays Corporate Bond Index

+11.7%

11.8

-12.4%

60/40 with Barclays Government Bond Index

+11.6%

10.9

-9.9%

65/35 with Barclays Government Bond Index

+11.9%

11.7

-11.6%

Stock allocation in each portfolio = 20% S&P 500, 30% DFA US Large Value Index, 50% DFA US Targeted Value Index.  Average Loss = average of declines during Bear Markets of 1973-1974, 1990, 2002, 2008, 2011

 

When we look at riskier bonds within the context of balanced portfolios in Table 2A, we see no benefit.  While the 60/40 stock and bond mix with Corporate Bonds had a 0.1% higher return than the same allocation with Government Bonds, that came with elevated risk. By adding 5% more in stocks (65% stock and 35% bond), we raised the risk of the Stock and Government Bond portfolio up to that of the 60/40 combination with Corporate Bonds, but earned 0.2% higher returns.

 

TABLE 2B

Stock/Bond Combinations

Annualized Return (1984-10/2012)

Standard Deviation (Risk)

Average Loss

60/40 with Barclays High-Yield Bond Index

+11.3%

12.9

-15.0%

60/40 with Barclays Government Bond Index

+11.0%

10.4

-7.6%

75/25 with Barclays Government Bond Index

+11.5%

12.9

-12.1%

Stock allocation in each portfolio = 20% S&P 500, 30% DFA US Large Value Index, 50% DFA US Targeted Value Index.  Average Loss = average of declines during Bear Markets of 1990, 2002, 2008, 2011

 

If we instead look at High-Yield Bonds in Table 2B, we come to very similar conclusions.  Using them as the bond component of a 60/40 stock and bond allocation does increase the portfolio return above the same mix with Government Bonds (+11.3% vs. +11.0%), but at the expense of much higher risk and double the losses during bear markets (see “average loss” column).  Simply raising the Stock allocation to 75% while maintaing the allocation to Government Bonds targets the same amount of risk (12.9), but historically increased returns by about 0.2% and actually experienced less in downside (-12.1% vs. -15.0% during bear markets).

 

Whether by themselves or within a balanced portfolio, history teaches us that risky bonds are a bad idea, and despite today’s record low interest rates, investors should resist the urge to “reach for yield”.

 

 

 Past performance is not a guarantee of future results.  Indexes are not available for direct investment and are used to convey broad economic principles. Their performance does not reflect the expenses associated with the management of an actual portfolio.