Saturday, 30 November 2013

The Role of High Yield Bonds in Your Income Portfolio

It's a percentage game...
The DIY Income Investor portfolio is based on an asset allocation split between high-yield dividend shares and high-yield fixed-income securities. As far as I am aware no-one has previously advocated or publicised such an asset allocation mix. Yes, the 50/50 equity/bond split recommendation is fairly commonplace - but not with the emphasis on high-yield.

While there is a lot of evidence supporting dividend investing and, perhaps more speculatively, high-yield dividend investing, there seems to be less evidence for the success of high-yield fixed-income investment. But there is some...

This post is based on the findings of Fidelity Investments research paper The Case for Investing in High Yield Funds.

The fixed-income securities in the DIY Income Investment portfolio are all type of capital-raising instruments and include things like corporate bonds, PIBS (Permanent Interest-Bearing Shares) and preference shares. Basically all these securities pay a fixed rate of return relative to the face value; some are 'permanent' and some have maturity or call dates, when the face value is repaid or the loan conditions changes.

The Fidelity Investments paper focuses on corporate bonds - fixed-interest loans to companies. High-yield corporate bonds - bonds classified as below 'investment grade' by the ratings agencies - became a recognised asset class in the 1980s. Sometimes called 'junk bonds', these securities carry significant risks, including default. However, by investing in a diversified fund - or preferably a cheaper ETF (exchange traded fund) it is possible to reduce the risk of outright loss.

The market in junk bonds peaked in around 1998 and then crashed with the collapse of the high-tech boom. It has since picked up and prices have been boosted by the low interest rate environment associated with worldwide government Quantitative Easing or QE.

The potential high returns from the high-yield bonds are potentially offset by the risks of volatility, early repayment and default and, of course, the perennial interest-rate risk that all fixed-income investments display (i.e. if general interest rates rise, the value of fixed-income securities will usually fall). Although these risks are very real, the paper notes that long-term investors have generally been well rewarded - with average returns of nearly 8.9% between 1986 and 2004 (by comparison, investment-grade bonds had a return of 7.8% whilst shares had a return of just over 12%).

The long-term returns from high-yield bonds lie between equities and investment-grade bonds. This is because the prices are sensitive to economic and financial factors affecting the corporate issuers (like shares) whilst retaining the fixed rate of return. In fact, the lower the grade of the high-yield bond, the more it is sensitive to these issues.

The 'yield spread' is the difference between the average high-yield return and 10-year Treasury bonds and averaged 5.2% over the period 1986-2003. This yield spread is a good indicator of the trend in the economic cycle. Yield movements can also anticipate corporate defaults.

However, history shows that most investors are not able to predict the markets - so investing in high-yield bonds is not suitable for those with short-term horizons.

The 'Holy Grail' of investing is high risk-adjusted returns, which are measured in academic studies using the Sharpe Ratio, which measures the ratio of the excess historical returns compared with a 'safe' return (such as 3-month Treasury Bonds in the US) divided by the standard deviation of the returns (standard deviation is a measure of variability or volatility). A high Sharpe Ratio shows above-market returns with a minimum of volatility.

The Fidelity Investments paper looks at the performance of a range of (US-based) portfolio asset mixes over the period 1985-2004 including different proportions of:
  • investment-grade bonds
  • high-yield bonds
  • 'domestic' (i.e. US) equities

The ranking in terms of the Sharpe Ratio (highest first) was as follows:
  • 30% IGB (investment-grade bonds)/ 70% HYB (high-yield bonds)
  • 50%/50% IGB / HYB
  • 70% HYB / 30% IGB
  • 100% HYB
  • 30% DE (domestic equities) / 70% HYB
  • 50%/50% DE / HYB
  • 70% DE / 30% HYB
  • 100% DE

In other words, the equities-only portfolio had the lowest Sharpe Ratio and the mainly high-yield bond-only portfolio had the highest Sharpe Ratio.

So, adding high-yield bonds (or, generalising, other fixed-income securities) to a portfolio will tend to bring down volatility without sacrificing the potential for superior returns. However, given the relatively high issuer-related risks associated with owning individual securities it is probably better to own a diversified fund, preferably in the form of a low-cost unleveraged ETF. The DIY Income Investor portfolio is still heavily invested in individual high-yield securities, although I have started migrating to suitable high-yield bond ETFs.

But a word of caution - it is different this time: QE around the world has pumped up the price of fixed-income securities (and equities): when this stimulus is removed, we can expect a fall in prices. Take a long-term view or concentrate on short-term maturities (so you are assured to get your capital back).

I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.


  1. Interesting post, which I will have to carefully consider

  2. Hi DIY,
    I have always wondered what happens to the capital value of high yield bond ETFs when of the holdings in the bond ETF defaults. Does the ETF invest in another company if this happens ?

    1. As with all collective investments, the portfolio takes a hit - but hopefully a small one. The problem is more serious if you are holding that security directly.

  3. Hi DIY,
    If I reinvest my coupons do these bonds behave like dividend shares, that I should see coupon growth, rather like dividend growth ?

    1. That's one way of looking at it! My own approach is to collect the income from all the portfolio and then choose the current higher-yielding investment (not necessarily the 'highest'), rebalancing the portfolio between shares and fixed-income. In other words, all the income is used to 'refresh' the portfolio, not just buy the same things again.

    2. Your method of aggregating your income to buy the current high yielding investment works well when you have a regular and significant amount of income. However for someone only just starting with income of a few tens or hundreds of pounds in a year an automatic re-investment works better. I have illustrated this in my blog as I have one large (SIPP) and one smaller (ISA) portfolio and use different methods in each one

    3. Martyn - do give us the details of your blog.

      My approach in earlier years was to aggregate the accumulated income with annual ISA/SIPP deposits. I'm not sure about the automatic re-investment, as you don't then have to think about whether it is a good thing or not!

  4. Yes, Martin, please share your blog with us!

    1. He's here:

      (found by clicking onto his name)