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How to Make Your Own High-Yield Corporate Bond Fund
With interest rates at low levels for a number of years now, many investors have moved some portion of their high-quality bond portfolios to higher-yielding investments like high-yield corporate bonds. I’ve long argued that there’s not much these strategies add relative to a traditional stock fund and high-quality bond strategy. Further, the traditional stock fund and high-quality bond allocation strategy tends to have lower costs and be more tax efficient. This is a bit of a qualitative argument though, and I wanted to illustrate the point quantitatively.

From this point of view, the basic idea is that you can replicate the performance of most high yield strategies using stocks and high-quality bonds. To test this, I ran an analysis to determine what allocation between Vanguard’s S&P 500 fund (VFINX) and Vanguard’s Intermediate-Term Treasury fund (VFITX) would have historically most closely replicated the performance of Vanguard’s High Yield Corporate fund (VWEHX). (I used the period of November 1991 through April 2013, as this is the longest period of time that I had returns data for all three funds.)

If my theory is true, we should see that the performance of VWEHX and the portfolio of VFINX and VFITX are basically the same or that the stock and bond fund portfolio has actually done better. If my theory doesn’t hold up, VWEHX should have outperformed the stock and bond fund portfolio.
This analysis finds that an allocation of 37 percent to VFINX and 63 percent to VFITX has most closely tracked the performance of the high yield fund. Here’s the performance comparison of those two portfolios:

I’m not making those numbers up, folks. The two portfolios generated virtually the same long-run return, but the stock and bond portfolio had a better risk-adjusted return due to lower volatility. The analytic conclusion is that there’s not much special about high-yield corporate bonds that investors couldn’t get by putting about 40 percent in stocks and 60 percent in high-quality bonds.

Random Commentary and Links of the Week
 
I thought this was really good, nerdy financial humor, but I’m not sure anybody else thought so:

 

Jared Kizer is the director of investment strategy for The BAM ALLIANCE. See our disclosures page for more information. Follow him on Twitter.
High-Yield Corporate Bonds
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Comments

It gets worse for HY!

Jared,

Good post.  The only "issue" I see with your comparison is using the S&P 500 as the stock surrogate for the equity risk in HY bonds.  If you look at the types of companies that issue HY debt they are value companies -- low prices relative to fundamentals with the highest cost of capital.  So to accurate compare a hybrid asset class like HY (which has a mix of equity and fixed income risks), you need to use pure bonds (treasuries) and value stocks.

In doing so, there isn't much of a comparison.  If we look at Vanguard's small value fund, their treasury fund, and high yield fund over the longest period possible (5/21/1998), we see the following growth of $10K for each strategy:

Small Value = $31,391
Int'd Treasury = $23,926
Junk Bonds = $23,800

Believe it or not, over a period where junk yield spreads (relative to treasuries) are approximately unchanged, we see that not only have junk bonds underperformed the stocks of companies that issue them (small value), they also underperformed the safest fixed income holdings (treasuries), despite the later gaining +13% in 2008 and high yield losing over 21%!

And we are being "kind" to HY here, as using Vanguard SV fund is setting the bar pretty low.  DFAs SV fund, over this same period, has grown to over $39K, almost 2% per year more than Vanguard's strategy.

Clearly, the portfolio "cost" to holding this junk is significant.  Investors who hold high yield bonds in a balanced portfolio have earned lower risk adjusted returns than necessary (a cost just like higher expense ratios), and advisors who have used junk bonds have delivered lower net-of-fee returns (a cost just like higher advisory fees).  Enlightened investors understand these points well.
at 6/14/2013 12:19 PM

SV

Completely agree w/ what you're saying. I was just making the general point that stocks + bonds can get you high yield results or better but you're absolutely right that SV is a better proxy for the equity like risks of HY.

JK
at 6/14/2013 8:37 PM

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