High-Yield Bond Funds Correlation With Equity

[Telly]

The latest issue of T. Rowe Price Investor has the following suggestion for sub-asset class diversification within Fixed Income:

70% Investment Grade Bond
20% High-Yield Bond
10% International Bond

It's the High-Yield part I want to talk about. I have stayed away from High-Yield bond funds in my FI allocation. Thoughts were that High-Yield bonds, if corporate in nature, would tend to track equities more than non-H-Y bonds would. If business conditions deteriorated, and equities were going down, then the companies whose bonds were deemed H-Y in nature were by definition out on the risk fringe, and thus likely to run into problems, maybe big problems!

So, it seems to me that adding H-Y bonds to FI is just an attempt to goose returns on the FI side, but also increases the correlation with equities (bad).

I would think that boosting the FI <--> Equity correlation is the last thing I would want to do, right? If I expect my equity side to be the growth powerhouse, why would I want to pollute my FI side by stepping out further on a FI branch that swings with the equity wind?

T. Rowe Price is usually pretty conservative in their writings. Am I missing something on the topic?

[Mysto]

Bonds are normally used to limit risk (variability) in a portfolio. HY bonds have quite a bit of variability and therefore aren't very good at dampening the swings.

Many experts feel that the slight extra yield of Hi Yield is not worth it and stay with short and medium (5 years and under) bonds.

Do a search on bonds in this group and should find a lot of additional info.

Hope this helps.

[ats5g]

Telly,

Larry Swedroe recently put down his thoughts about HY bonds in a conversation over at the VD forum.

- Alec

[haha]

High yield bonds are a poor investment but at the right time a very good speculation. Now is not the right time.

Ha

[audreyh1]

High-yield bond funds do indeed tend to perform poorly at the precise time that equities are taking a brutal hit. If you think about the economics of it, when the economy suffers is when the companies with marginal credit quality tend to go belly-up and as a result credit spreads widen sharply, punishing high yield bonds across the board. Just look at 2001/2002 and you'll see how very poorly high yield bonds performed at the same time that the equity markets did so badly.

As a consequence, high yield bonds don't make a good balance for equities. On the other hand, high-quality bonds do make a good balance for equities. It is precisely when the economy suffers/we are in a recession, that there tends to be a "flight to quality" (bonds).

I only hold high yield bonds through "total return" type bond funds where I rely on the fund manager to know when high yield is a good deal relative to other bond types and when it is not.

Audrey

[FIRE'd@51]

Quote:

Originally Posted by HaHa High yield bonds are a poor investment but at the right time a very good speculation. Now is not the right time. Ha

Everyone on here seems to say this, and I'm certainly no expert on high yield bonds. Vanguard High-Yield Corporate fund (VWEHX) has a yield of 7.05% and Vanguard Intermediate Treasury fund (VFITX), which has a similar duration, yields 4.47%. Although the spread (2.58%) is narrow by historical standards, the yield ratio is 1.58, so the high-yield fund throws off 58% more income. Is this ratio way out of line with historical values? I guess I'm wondering if one should be looking at yield ratios instead of yield spreads, and that the spreads are lower because interest rates are lower?

[JPatrick]

Take a peak at FAGIX--A touch different from the typical HY, but those 5 year returns are really juicy. Yes it does have a track similar to equities.
Not a HY fund, but one that is pretty steady is FFRHX. Higher yield than MM and IMO not that much more risk. And...no real equity correlation.
I really don't have any feelings one way or the other as to the timing of new purchases.

[haha]

Quote:

Originally Posted by FIRE'd@51 I guess I'm wondering if one should be looking at yield ratios instead of yield spreads, and that the spreads are lower because interest rates are lower?

I guess if you have a database of ratios that you feel is valid then it would be best to look at ratios. I look at in 2 ways. One, the arithmetic spreads are historically very narrow, paying no attention at all to absolute levels. The spread peaked sometime in the early 21st century, and came down strongly as the recovery came about. But recently they have stalled in this movement. Does this mean spreads will again widen? No, but it may mean that they are not likely to fall much more, and we know that historically they have varied so it looks as if today’s junk buyer may have a one way bet in the wrong direction.

This means that the buyer would have to look to excess annual coupon payments as the source of his excess return over high quality paper. In the cases you cited, the excess annual return for a $100,000 investment in junk would be $2680 pa, or $13,400 over 5 years. So if the junkman experienced no defaults until the end of 5 years, he could then accept a 13.4% capital loss to bring him back to even with high quality. I ignore re-investment, as I also created the highly unlikely scenario in which there were no defaults along the way. These simplifications may pretty well cancel one another.

If this seems like a good bet buy the junk. To me it does not seem to be a good bet.

Ha

[chinaco]

It is a personal investment choice. I have decided to avoid junk in any large way. I mainly invest in High Quality Bonds... inside of a fund. I have considered putting 2 or 3% in junk. Mainly for the diversification. Hopefully it will yield cap gains when other investments are not doing well. That said... 2 or 3% will not make much difference in overall cap gains... so I am not sure it is worth it. Although, they should throw off a larger yield ongoing.

I am not a timer... so I would not try to use it as a temporary measure. Rather as part of an overall diversification strategy.

[ERD50]

Quote:

Originally Posted by HaHa High yield bonds are a poor investment but at the right time a very good speculation. Now is not the right time. Ha

I'm no expert on this either, but I gotta wonder about that statement. If the spread between junk and Hi-Q bonds is historically low, would that not also mean the current NAV of the junk funds is low also? People who seem to know are saying, don't buy junk now, the yield spread is too low. So, if nobody is buying, isn't that driving the NAV down?

So, couldn't this be a *good* time to be buying? As you say, we have no crystal ball, but with the low current spread the odds seem against further significant drops in the spread.

The default risk in Vanguards fund seems pretty low. I do understand audreyh1's comment, that HiQ bonds will provide some reverse correlation to stocks - so that is certainly something to consider in overall asset allocation. I tend to look at my junk fund as a hybrid between stocks and bonds.

-ERD50

[ats5g]

I'm no expert either, but:

Quote:

If the spread between junk and Hi-Q bonds is historically low, would that not also mean the current NAV of the junk funds is low also?

If I'm reading your question correctly, I believe you've got it backwards. If the J-T spread is low, then the yields on junk bonds are low, and their prices are high. Thus, the NAV on junk funds would be high.

Quote:

People who seem to know are saying, don't buy junk now, the yield spread is too low. So, if nobody is buying, isn't that driving the NAV down?

If not sure that "nobody is buying". My guess is that performance chasers are buying, driving the prices of the junk bonds up, and their yields down.

Quote:

So, couldn't this be a *good* time to be buying? As you say, we have no crystal ball, but with the low current spread the odds seem against further significant drops in the spread.

If the odds are against further significant drops in the spread, that would lead little upside for higher returns for Junk, wouldn't it? Remember that a drop in the spread means good returns for junk vs treasuries, and a increase in the spread means bad returns for junk vs treasuries. [I think I got that right ]

From my rough calculation Vanguard's junk fund has lost about 2% per year to defaults/capital losses.

- Alec

[jIMOh]

Quote:

Originally Posted by Telly The latest issue of T. Rowe Price Investor has the following suggestion for sub-asset class diversification within Fixed Income: 70% Investment Grade Bond 20% High-Yield Bond 10% International Bond It's the High-Yield part I want to talk about. I have stayed away from High-Yield bond funds in my FI allocation. Thoughts were that High-Yield bonds, if corporate in nature, would tend to track equities more than non-H-Y bonds would. If business conditions deteriorated, and equities were going down, then the companies whose bonds were deemed H-Y in nature were by definition out on the risk fringe, and thus likely to run into problems, maybe big problems! So, it seems to me that adding H-Y bonds to FI is just an attempt to goose returns on the FI side, but also increases the correlation with equities (bad). I would think that boosting the FI <--> Equity correlation is the last thing I would want to do, right? If I expect my equity side to be the growth powerhouse, why would I want to pollute my FI side by stepping out further on a FI branch that swings with the equity wind? T. Rowe Price is usually pretty conservative in their writings. Am I missing something on the topic?

You may not be missing anything (based on post), but remember the 20% is part of 40% in "non equity" (assuming an overall 60-40 porfolio), so this is an 8% position of overall portfolio. If this is "rebalanced", then when junk has it's run, make sure to take the profits, and when it falls, buy more.

If you leave it be, then I think you are taking too much risk.

For example, I own PREMX. It's an emerging markets (junk) bond fund. It has had a good run and went well past the 5% I want it to be. I am cashing in those gains expecting this to lag, (cashing in will drop to ~2.5%?). Within a year I'll sell something else to get this back to 5%, then look for another run upward.

[FIRE'd@51]

Quote:

Originally Posted by ats5g From my rough calculation Vanguard's junk fund has lost about 2% per year to defaults/capital losses.

When you say capital losses, I assume you mean yearly drops in NAV. As I understand it, these could come from any of the following:

(1) a general widening of credit spreads between junk and Treasuries

(2) a drop in price of specific bonds in the portfolio due to defaults

(3) a general rise in interest rates

Since (3) would affect Treasuries as well, only (1) and (2) are of concern here. Is (3) included in your 2% per year number? If so, do you know what part of the 2% comes from (1) and (2)?

[ats5g]

Quote:

Originally Posted by FIRE'd@51 When you say capital losses, I assume you mean yearly drops in NAV. As I understand it, these could come from any of the following: (1) a general widening of credit spreads between junk and Treasuries (2) a drop in price of specific bonds in the portfolio due to defaults (3) a general rise in interest rates Since (3) would affect Treasuries as well, only (1) and (2) are of concern here. Is (3) included in your 2% per year number? If so, do you know what part of the 2% comes from (1) and (2)?

Very good questions. Now where the "H-E double hockey sticks" is brewer to answer. All I did was copy and paste the Capital Returns, Income Returns, and Total Returns since inception from VWEHX's annual reports into Excel, then averaged and annualized them.

Re #1: No idea what the spread was in 1979-80 [roughly when VWEHX started]. Could be though. According to Credit Risk: How Much? When? the J-T Spread was around 4% in 1988.

I ruled out a change in the general level of interest rates because since the early 1980's the other Vanguard bond funds [long, IT, ST] had less than 3-10% of their returns from capital return, even though interest rates were much higher. So, interest rates fell, but didn't add that much to bond returns. Kind of shoots the argument that the bond bull market was fueled by falling interest rates. See also this from an old Vanguard article on the S&P 500 return vs. the LBA return :



I'm going with #2 as the main culprit, but have no real good data to back that up.

- Alec

[boutros]

Here are the #s for yields for given indexes since 86. Lets see what this looks like...

G001 G0QO MGNM C0A0 H0A0 IGOV
GMNA Emerg Mkt
90 day US Treas Master Corporate Hi Yld Sovergn
Date US T-bill Master all 30 yr Master Master Plus
12/31/1986 5.797 7.02 8.74 9.11 12.14
12/31/1987 5.600 8.41 9.89 10.04 13.51
12/31/1988 8.760 9.18 10.27 10.15 13.39
12/31/1989 8.436 8.04 9.31 9.38 14.79
12/31/1990 7.476 7.77 9.20 9.62 17.89
12/31/1991 3.886 6.02 7.71 8.02 13.45 11.35
12/31/1992 3.147 5.93 7.09 7.71 11.62 13.41
12/31/1993 3.085 5.26 6.59 6.71 9.83 9.29
12/31/1994 5.695 7.82 8.75 8.67 11.33 15.52
12/31/1995 5.084 5.55 6.93 6.56 9.91 12.48
12/31/1996 5.198 6.25 7.40 7.09 9.70 9.99
12/31/1997 5.354 5.85 6.96 6.68 9.06 9.81
12/31/1998 4.470 4.94 6.54 6.24 10.52 13.18
12/31/1999 5.346 6.54 7.65 7.71 11.12 12.43
12/31/2000 5.894 5.44 7.01 7.32 14.17 11.55
12/31/2001 1.731 4.46 6.26 6.27 12.76 10.24
12/31/2002 1.170 3.12 4.13 5.11 12.03 9.83
12/31/2003 0.906 3.34 4.59 4.48 8.02 6.92
12/31/2004 2.011 3.73 4.68 4.71 6.49 6.70
12/31/2005 4.070 4.44 5.40 5.40 8.13 6.56
12/31/2006 4.967 4.80 5.66 5.68 7.63 6.41
1/31/2007 5.110 4.91 5.77 5.76 7.58 6.56
2/28/2007 5.136 4.63 5.59 5.49 7.39 6.42


Well it doesn't look the greatest but since 86 HY to IG corp spread has topped out at ~8% and HY to treasury toped out around 10%. It is currently at 1.9% and 2.7% respectively. I am underweight HY now but watching spreads to see where they are larger or smaller than normal. Of course investors have gotten better at evaluating credit risk so the spread should be lower than the average but I think that the spread is too low.

[haha]

Sometimes it is possible to think too much. You guys are thinking too much.

What might bring interest rates down? Bad economy and credit stress leading to Fed rate cuts.

What would happen then? Rates on new US govt debt would fall, causing prices on existing US govt debt to rise.

What would happen to junk? Interest rates on junk would rise, and prices would fall, because price pressure from concern over credit quality and defaults would swamp any price effect of falling interest rates on high quality bonds. Additionally, defaults would increase from their very low rates at present.

But hey, be my guests! Just remember to report back in a couple of years and share how it played out for good or evil.

Ha

[boutros]

as to correlation question see below for Q to Q correlation figures since 86

[FIRE'd@51]

Thanks, boutros

That's some good stuff. For comparison, do you happen to have a correlation coefficient for long Treasuries vs S&P 500 over that same time period?

[ERD50]

Quote:

Originally Posted by HaHa Sometimes it is possible to think too much. You guys are thinking too much.

Thanks for that - my brain was starting to hurt.

Quote:

What would happen then? Rates on new US govt debt would fall, causing prices on existing US govt debt to rise. What would happen to junk? Interest rates on junk would rise, and prices would fall, because price pressure from concern over credit quality and defaults would swamp any price effect of falling interest rates on high quality bonds. Additionally, defaults would increase from their very low rates at present.

I'm slow with these bond and bond fund relationships - let me make sure I got this. When you say 'Interest rates on junk would rise" I take that to mean that interest rates on a junk fund would rise relative to it's NAV, because the NAV would drop (due to increased default risk). So a new purchaser would see higher interest rates from junk.

A current holder of the fund wouldn't see a big change in rates (based on his purchase price - yes, I know, not the proper way to look at it), but a drop in NAV.

I realize the J-T spread is low, but I can't help but think, where else could I get that extra 2.5% rate? And, if the NAV smoothes out over the long term, and is roughly half as volatile as stocks, what's the problem?

Now, I am thinking even more, and I realize, since the junk NAV roughly correlates with stocks, I really would not want to sell them off in a bear market. So, they probably do not belong in my 'bond' asset allocation bucket, but in my 'hi-dividend-stock' allocation bucket. Does that make any sense?

-ERD50

[haha]

Quote:

Originally Posted by ERD50 Thanks for that - my brain was starting to hurt. I'm slow with these bond and bond fund relationships - let me make sure I got this. When you say 'Interest rates on junk would rise" I take that to mean that interest rates on a junk fund would rise relative to it's NAV, because the NAV would drop (due to increased default risk). So a new purchaser would see higher interest rates from junk. A current holder of the fund wouldn't see a big change in rates (based on his purchase price - yes, I know, not the proper way to look at it), but a drop in NAV.

I find it easier to think in terms of a bond, not a bond fund. Since a fund is just an aggregation of individual bonds, the interest/ price/ credit relationships are the same.

While a bond fund has an NAV, an individual bond has only a face value, a coupon, and a market price. If there is credit stress in the economy people will pull back from their bids on low quality bonds, causing the market prices to fall. This is really all you need to know about that. This may very well happen at the same time that treasuries are being bid up in price, since they are perceived and being devoid of credit risk.

As regards inter asset correlations, T bonds are very unlikely to have a greater correlation with equities than junk, and very likely will have much smaller positive or even a negative correlation.

My take home is that there is credit risk in low quality bonds, and the buyer needs to be well compensated for this. The upside is capped, the downside is open. The AAA/junk spread is one look at how much cushion junk buyers are demanding for credit risk.

Ha