High Yield Bonds: Fixed Income or Equity?

June 26th, 2012 by

By Barry Rabinowitz of BER Financial Group

(June 2012) In a zero interest rate environment, individual investors have been flocking to High Yield Bond Funds, in search of yield. With returns of around 7%, vs US Treasury 10 year rates of 1.7%, they make a lot of sense as yield enhancement vehicles.

 

However, I take issue with the consensus that high yield is a bond allocation.

If it looks like equities, trades like equities, and is not adversely affected by interest rate increases, in my opinion, it is not a bond, but an equity equivalent.  Traditionally, bonds have been used to reduce the volatility and risk of an equity portfolio. They usually zig when equities zag, and vice versa. In periods of a growing economy, when the demand for credit is increasing, interest rates rise and and prices fall. Conversely, when the demand for credit is falling, during periods of slow growth or recession, interest rates fall and bond prices rise.

The 2008-2010 period highlights the relative performance of High Yield, US  Treasuries and equities, during a year of financial panic (2008) and a subsequent rebound (2009-2010).  In 2008, the S&P 500 fell almost 38%…

S&P 500 Daily Chart 2007-2012

The Barclays Aggregate Bond ETF, AGG, which was 36% US Treasuries, did what it was supposed to do, and  rose 6%:

AGG Daily Chart 2007-2012

What about High Yield?  Unlike the Barclays Aggregate,  the iShares high yield bond fund, HYG,  fell 24%. It did not offset the volatility of equities, but fell 2/3 as much as the iShares S&P 500.

HYG Daily Chart 2007-2012

What happened in 2009, when the predicted economic collapse failed to materialize?

The S&P rose 26%, and the high yield index, HYG, rose 40%, vs 5% for the Barclays Aggregate Bond Fund. Once again high yield mimicked equity, more so, than fixed income.

What about 2010?

The S &P had a total return of 15%, whereas high yield returned 12% and Barclays aggregate bond fund, AGG, returned 6%.

What about risk?  

Standard deviation is widely accepted as the measure of risk or volatility in an investment. For the past 3 years the standard deviation, or volatility of the S&P 500 was 16%, vs 9% for high yield, HYG, and less than 3% for AGG.

 

My Conclusion

High Yield should be part of an equity, not fixed income allocation, and I would suggest up to 25%  of the equity allocation. High yield is an appropriate allocation for investors seeking equity type returns, but with about 50% less risk.

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