“As Fama put it, “Life always has a fat tail.”” ― Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management
High yield bonds are fixed income securities with a lower credit rating than investment grade corporate bonds or Treasuries. These bonds are believed to have a higher risk of default; to compensate for this, investors demand a higher yield. Their returns tend to be more pro-cyclical, and are more correlated to equities than traditional fixed income.
One curious characteristic of high yield bonds is that they have historically provided equity-like returns but with significantly less volatility. As such, the volatility-adjusted returns from high yield bonds have been higher than that for equities. This observation might be perplexing to some. Since high yield bond returns are so correlated to equity returns, investors can just improve their portfolio’s volatility-adjusted returns by shifting from equities into high yield bonds. This would, in turn, lead to lower returns on high yield bonds, and ultimately similar volatility-adjusted returns as equity. Here, we would suggest two potential reasons for why this hasn’t happened: a risk-based factor and an institutional factor.
According to Modern Portfolio Theory, the returns from an asset should be positively related to its risk. Conventionally, risk has always been measured by the volatility of returns. However, volatility is only one narrow measure of risk. There may be other risks within high yield bonds that investors need to be compensated for, yet aren’t captured by conventional volatility measures. For example, it is generally accepted that high yield bonds tend to be less liquid than a typical stock. Therefore, high yield investors shouldn’t just be compensated for business/macroeconomic risks as with stocks, but also illiquidity risk.
A more detailed look at the underlying distribution of returns illustrates this point; high yield bond returns have a more negative skew and higher kurtosis than equities, meaning that they are more prone to ‘fat-tail’ losses, with a liquidity crash being one such example. Therefore, investors shifting from equities into high yield bonds may be simply just substituting one type of risk for another.
Investors are faced with many constraints, with one of the more prevalent constraints being the inability to leverage. To understand how this has anything to do with our puzzle, note that high yield absolute returns are generally lower than equities, despite having higher volatility-adjusted returns.
In a simplified setting, suppose that a leverage-constrained investor is only restricted to having high yield bonds or equities in their portfolio, offering an annualised return of 8% and 10% respectively. If the investor requires a return above 8%, they will either have to leverage a pure high yield portfolio, or to incorporate more volatile equities into their portfolio mix. Since the investor cannot leverage, they are obviously forced to rely on the latter. This will increase demand for equities, thus distorting its volatility-adjusted returns downwards relative to high yield bonds. To put it simply, high yield bonds may have better volatility-adjusted returns because markets aren’t frictionless enough to exploit this fact.
High yield bonds’ better volatility-adjusted return is closely linked to the low-volatility anomaly, where stocks with lower volatility tend to have higher volatility-adjusted returns. The same pattern has been observed across wider asset classes we well – evidence that leverage-constrained investors are forcing their capital into more volatile assets to improve portfolio returns.
The point to emphasise is that there is no free lunch here. In attempting to achieve superior volatility-adjusted returns by using leverage to invest heavily in high yield bonds, one must accept their greater tail risk as well as the risks of leverage itself. As it stands, our Strategic Asset Allocation (SAA) process is already designed to provide the most efficient portfolio given the expected risk-return characteristics of our investable asset classes. Unless one has the ability/willingness to leverage, it is best to just leave your high yield – equity allocation in line with the recommended SAA.