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The Scoop on High Yield Bonds
Old 12-01-2003, 07:32 AM   #1
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The Scoop on High Yield Bonds

Back on Nov. 21 I said in a post that was refining some research that I had done on the performance of high yield bonds (as an asset class).

As with other assets, high yield bonds offer the chance to reduce the risk of a portfolio (the fluctuation in annual returns) because their annual returns are imperfectly correlated with those of other asset classes. *I'll note up front that the comparisons between high yield bonds and other asset classes will vary depending upon the time period studied and the index used. *There are several indexes of high yield bond performance (and also of small cap stock performance), and none are as generally accepted as the S&P 500 for large cap stocks. But I'm sure that essentially the same relationships would appear regardless of the indexes that are used to measure them.

A few years ago, T.Rowe Price presented, in its newsletter, the following data on correlation coefficients between high yield bonds and other asset classes. *The data was based on just 5 years ending September 30, 1996. *The correlation of high yield bonds with "high grade" bonds was R=0.46; with "large cap" stocks, R=0.28; and with "small cap" stocks, R=0.37. *Although the data set was pretty limited, it was sufficient to illustrate that the correlation between high yield bonds and other bonds was only modest, and that the correlation with stocks was low (although higher with small caps than with large caps).

It occurred to me, though, that there might be a higher correlation between high yield bonds and a mix of other bonds and stocks, since high yield bonds are subject to both interest rate risk (like bonds) and solvency risk (like stocks). *And sure enough! *Here's what I found, based on 18 years of data from 1985 through 2002. *I used the Russell 2000 as the index of small cap stocks, and the Lehman High Yield Index as the index of high yield bonds (which is used by Vanguard as the benchmark for its High Yield Corporate Fund).

Through trial and error, I found that the strongest correlation occurs between high yield bonds and a portfolio consisting of 67% small cap stocks and 33% long term corporate bonds (as measured by Ibbotson Associates). *The correlation in the annual returns is R=0.86, which is quite high.

Furthermore, the risk/return characteristics over the period were very similar. *The small cap/long term corporate bond mix had an average annual return of 9.8% with a standard deviation of 13.1%, while the high yield bonds had an average return of 11.1% with a standard deviation of 13.6%. *(Using a different index for small cap stocks would indicate a slight advantage for the stock/bond mix.)

The general conclusion here is that, over time, market efficiency does its thing and prevents high yield bonds from performing much differently than a mix of assets that are subject to similar economic risks.

Including high yield bonds in a portfolio can still be expected to have the benefit of reducing its risk slightly. *But in deciding whether to include high yield bonds in a portfolio, tax considerations become more important, in that most of the gain from high yield bonds is taxable interest, while most of the gain from a mix of small cap stocks and corporate bonds would be capital gains.
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Re: The Scoop on High Yield Bonds
Old 12-01-2003, 04:29 PM   #2
 
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Re: The Scoop on High Yield Bonds

So Ted, I guess since I just loaded up on high
yield bonds in my IRA, you would say that is okay
as long as I am diversified and can leave the income
in a tax--deferred account. Right?

John Galt
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Re: The Scoop on High Yield Bonds
Old 12-02-2003, 05:08 AM   #3
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Re: The Scoop on High Yield Bonds

John G,

By investing in high yield bonds, you essentially exposed yourself to the risk/return characteristics of small cap stocks in spite of your aversion to them. But that's fine as long as you have other assets in other accounts. Retirement accounts are good places to hold high yield bonds -- especially for people who are still working and have higher taxable income -- because the high interest payments are then not subject to current income taxes.

One nasty feature of high yield bonds held in a taxable account is this. In years when they have negative total returns, they still are paying considerable interest, which is taxable. The losses, however, are in the drop in their market price. If you sell the bonds, the loss is a capital loss and you can only claim $3,000 loss per year (a highly antiquated and unfair provision of the tax code). Or, if you hold the bonds, the loss is unrealized and does not reduce your taxes. So high yield bonds can be a poor investment from a tax standpoint.
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Re: The Scoop on High Yield Bonds
Old 12-02-2003, 06:48 AM   #4
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Re: The Scoop on High Yield Bonds

Ted

We hold Vanguard High Yield Corporate in a taxable account and treat them as an income stream ignoring market fluations. I treat them the same as pensions when running FIREcalc. Our intended holding period is "forever" with no intention of ever including them in the "portfolio". Within the "portfolio"(IRA) we do have small amounts of Vanguard REIT and small cap value which will get rebalanced when/if our 50/50 stock/bond gets more than 10% out of whack. I'm counting REIT's as stock- which I have second thoughts periodically given their sensivity to interest fluations.
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Re: The Scoop on High Yield Bonds
Old 12-03-2003, 07:42 AM   #5
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Re: The Scoop on High Yield Bonds

Unclemick,

It sounds as if you are getting good diversification, but as I have said in other posts, I don't think too highly of accounting for assets by placing them in imaginary "baskets." Some people talk about calculating a present value for their social security or pension benefits and treating that like a "bond" in asset allocation, whereas you are doing the opposite in treating your high yield bond interest as a "guaranteed" income stream.

If you don't have a lot of earned income, the taxes that you pay on your high yield bond interest are probably not at too high a rate. But there are two ways that your high yield bond income could lose real value: (1) as the result of inflation reducing its purchasing power and (2) as the result of defaults reducing the amount of the interest payments. Investors expect a certain percentage of high yield bonds to go into default, and this percentage will probably remain relatively modest as the economy picks up. But if and when another slump occurs, the default rate will go up, and by then considerable inflation will also probably have occurred.

So I would caution you to consider all of your investments as part of a single portfolio and not rely on any one part of it to meet your spending needs. FIRECalc is the best tool that I have seen for analyzing the level of spending that can be sustained from both your investments and your benefits from social security and/or pensions. Its main limitation is that it only permits a user to analyze a portfolio consisting of large cap stocks and one type of bonds. However, the way to get around this limitation is to (1) run FIRECalc to determine a "target" allocation of stocks and bonds, and then (2) substitute other assets for a portion of the large cap stocks and bonds, on the basis of their similarity to large cap stocks and bonds. That is the value of knowing what I posted about high yield bonds acting about 2/3 like small cap stocks and 1/3 like long term corporate bonds. Furthermore. something on the order of $8 to $9 invested in small cap stocks is equivalent in risk and return to $10 invested in large caps.

At least over the past decade REITs have had the desirable characteristic of having a very low correlation with stocks in annual returns, while delivering similar total return. I haven't yet investigated to what extent the return on REITs correlates with a mix of stocks and bonds or T-Bills. For now, for purposes of asset allocation, I regard REITs as if they are about 50% large cap stocks and 50% corporate bonds.
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Re: The Scoop on High Yield Bonds
Old 12-03-2003, 02:09 PM   #6
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Re: The Scoop on High Yield Bonds

Ted

Nice post. You touched on an EMOTIONAL issue which (even knowing better) I've never overcome - i.e. dividends/interest being more valued than market valuations. This effect has been writen up over the decades by many observers. Along with portfolio drops being more traumatic than gains enjoyed.

FIREcalc. gives a higher SWR when all bonds/stocks are included - like close to double. Will play with more runs trying to reflect your suggestions re correlations.

I still look at the SEC yields of our portfolio funds as a 'safe' bird in hand - just can't help it!
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Re: The Scoop on High Yield Bonds
Old 12-04-2003, 04:14 AM   #7
 
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Re: The Scoop on High Yield Bonds

Hello unclemick. Agree that Ted does a nice job.

My emotional view of this is just like yours, including
my view of most of the money in bonds, i.e. that my
holding period is forever. Thus, I tell myself to ignore
the market fluctuations as long as I get the income stream. Tough to do though. Totally agree with the
theory that drops in market value are much more
traumatic than any gains. I've been around a while,
but I am a notorious second-guesser which adds to
my angst.

John Galt
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Re: The Scoop on High Yield Bonds
Old 12-04-2003, 05:43 AM   #8
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Re: The Scoop on High Yield Bonds

I've reread the Scott Burns/Bogle 10/25/03 interview several times and done some poking around Berstein's Efficient Frontier website for correlation articles.

Will be running a lot of 'total' portfolio sims along the lines Ted suggested in FIREcalc. After ten years in ER - it's time to get serious about spending money - although we have no current 'wants' I'm sure someone will think of something next year - toys/travel/entertainment?
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Re: The Scoop on High Yield Bonds
Old 12-04-2003, 12:24 PM   #9
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Re: The Scoop on High Yield Bonds

It is certainly rational to prefer actual interest or dividend payments now, over the possibility of potentiually greater payments at some time in the future (which is what gives "growth" stocks all of their value and "value" stocks a good part of their value).

One plausible scenario is that (1) there will be an economic recovery that will substantially reduce the default rate on high yield bonds and thus provide good returns to the bondholders, but that (2) the economic growth rate will be less than in the past, thereby causing stagnation or even losses in the value of stocks -- especially growth stocks. This is a good reason for holding some high yield bonds.

Although it is generally best to hold high yield bonds through a mutual fund that provides a lot of diversification among them, I have occasionally owned the bonds of individual issuers. In one case, I owned the bonds of a faltering airline. Although it was managing to make the interest payments -- and these represented a yield of 14% or so based on what I had paid -- the value of the bonds was dropping as the interest was paid because the company was liquidating its assets to pay the interest. So I not only didn't have a net gain, but I was paying tax on the interest as regular income while getting no tax break on the unrealized losses. When I finally sold the bonds, the loss was a capital loss that did not offset the tax I had paid on the interest. This won't always happen, of course, but it is a possibility to consider.
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Re: The Scoop on High Yield Bonds
Old 12-04-2003, 01:03 PM   #10
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Re: The Scoop on High Yield Bonds

Ted

? It wasn't Eastern Airlines was it? Seems to me our investment club(back when I worked) lost money on both the stock and the bonds.
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