The Investment Scientist

High-Yield Bonds: Higher Risks, Lower Returns

Posted on: April 21, 2011

In 1993, the Journal of Financial Economics published “Common risk factors in the returns of stocks and bonds” by Fama and French. They examined bond returns in particular through the lens of various asset return models.

Let’s look at one of those models: the Fama/French three-factor model. The regression statistics of various bond classes are summarized in the table below:

Bond class 1-5G 6-10G Aaa Aa A Baa <Baa
Alpha 0.72% 0.84% -0.84% -0.85% -0.96% -0.6% -1.32%
Beta 0.1 0.18 0.25 0.25 0.26 0.27 0.34
S -0.06 -0.14 -0.12 -0.11 -0.09 -0.04 0.04
V 0.07 0.08 0.14 0.15 0.16 0.2 0.23

Explanation of the table

1-5G denotes Treasuries with less than 5 years to maturity, and 6-10G denotes Treasuries with 6 to 10 years to maturity. “Aaa” and the others letter combinations simply denote bond classes of a given credit rating; <Baa is commonly called high yield bonds.

The three factors are market risk (Beta) factor, small cap risk (S) factor, and value risk (V) factor. The table sums up each bond class’ exposure of Beta, S and V risks.

What we learn from the table?

  1. Higher yielding (lower credit quality) bonds have lower risk adjusted returns. (Alpha row)
  2. Higher yielding (lower credit quality) bonds have more exposure to the market risk factor; therefore, they are more correlated with the S&P 500. (Beta row)
  3. Government bonds have negative correlation with the small cap risk factor. (S row)
  4. Higher yielding (lower credit quality) bonds have higher correlation with the value risk factor. (V row)

Application to portfolio construction

High-yield bonds have negative alpha and strongly positive beta. Their inclusion in a portfolio could actually result in lower portfolio returns and higher portfolio risk. On the other hand, government bonds have negative exposure to the small cap risk factor and small exposure to the value risk factors. Inclusion of government bonds and small cap value stocks would result in higher returns and lower portfolio risk.

It is tempting to add high yield bonds to the portfolio mix. However, their effect should not be considered outside of the context of the portfolio mix and risk adjusted returns. Judging from academic research and practical evidence, it is not a smart decision to include high yield bonds in your portfolio.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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