High-Yield Bonds and Your Portfolio: Part 1

October 4, 2010

With income trusts facing new rules in 2011, investors are looking for other income-producing securities to fill the gap. Many are looking for a one-two punch of dividend-paying stocks and high-yield bonds.

Four new ETFs holding high-yield bonds have appeared in the past 12 months: the BMO High Yield US Corporate Bond ETF (ZHY) was first on the scene, launching last October. In January, the Claymore Advantaged High-Yield Bond ETF (CHB) and iShares U.S. High Yield Bond Index Fund (XHY) appeared within weeks of each other. More recently, on September 22, BlackRock added the iShares DEX HYBrid Bond Index Fund (XHB), the first ETF to invest in high-yield bonds issued by Canadian companies.

The growing appeal of high-yield bonds shouldn’t be surprising in an era when five-year Government of Canada bonds are paying just 2.5%. Investors are hungry for yield, and they appear to be willing to take more risk to get it. But are these bonds a good addition to a portfolio, or do their big payouts come with too much volatility?

What are high-yield bonds?

Before considering that question, let’s clarify what high-yield bonds are. Standard & Poor’s assigns all bond issuers a rating between AAA and D according to how likely they are to meet their debt obligations. The bonds of companies rated AAA (“Extremely strong capacity to meet financial commitments”) through BBB (“Adequate capacity”) are called “investment grade.” Companies ranked BB or lower are more likely to have trouble meeting their commitments. Their bonds are deemed “speculative grade” by S&P, and are often called “junk bonds” by investors. The financial industry prefers the more positive-sounding “high-yield bonds.”

As the name suggests, high-yield bonds reward investors for the added risk with higher interest payments. The current yield to maturity on AAA-rated corporate bonds in the DEX All Corporate Bond Index is just 2.2%, rising to 4.1% for BBB-rated issues. B-rated bonds yield a hefty 8.7%, and if you’re willing to reach as low as CCC, you may earn 10% — as long as the issuer doesn’t default, of course. (These numbers come from the information sheet for XHB.)

It’s clear, then, that high-yield bonds present an opportunity to earn substantial returns. So now that there are plenty of ETFs tracking this asset class, should high-yield bonds be part of a well diversified index portfolio?

There’s no simple answer. I went to four of my favourite financial authors for some guidance, and two came down on each side. Today we’ll look at the arguments against high-yield bonds, and on Wednesday we’ll consider the reasons why they may indeed have a place in a Couch Potato portfolio.

The argument against: “Bonds should be safe.”

The strongest argument against high-yield bonds is that fixed-income investments are supposed to provide ballast in a portfolio. If you want to take more risk in pursuit of higher returns, the thinking goes, then take it on the equity side.

Government bonds may have low yields these days, but they also have a very low correlation with equities: they tend to go up when stocks go down, and vice-versa. This is especially true during times of crisis, when investors are running for safety. When just about everything else went into freefall between September 2008 and March 2009, for example, government bonds rose in value by more than 5%.

High-yield bonds, on the other hand, offer none of this safety. Indeed, when equities crash, high-yield bonds tend to plummet along with them. According to Rob Carrick’s column in Saturday’s Globe and Mail, “in 2008, amid the worst conditions imaginable, high-yield bond funds lost 15.3 percent on average and some big players lost between 20 and 40 percent.”

Larry Swedroe, who writes the excellent Wise Investing blog on CBS MoneyWatch, takes a long-term look at this issue in a recent post called High-Yield Bonds’ Effect on Portfolios. Swedroe found that over the 20-year period ending in 2009, high-yield bonds outperformed five-year Treasuries by about 0.5% annually. Then he compared the performance of two portfolios with 40% bonds and 60% stocks. Portfolio A included only high-yield bonds on the fixed-income side, while Portfolio B included only five-year Treasuries. Both were rebalanced annually.

The surprising result: over two decades, Portfolio A had slightly lower returns and dramatically higher volatility than the Portfolio B. The Treasury bonds had a negative correlation with stocks over that period: when one asset class zigged the other tended to zag, smoothing out the investor’s ride. With regular rebalancing, the safer portfolio also yielded higher returns.

David Swensen, Chief Investment Officer at Yale University and the author of Unconventional Success, takes an even stronger position on high-yield bonds. The portfolio he suggests in his book includes only government (nominal and real-return) bonds on the fixed-income side. Swensen argues that the marginally higher returns of investment-grade corporate bonds are not worth the added risk: “Under normal circumstances investors receive scant compensation for the disadvantageous traits of corporate debt,” he writes. Investors in high-yield bonds face an even worse risk-return trade-off.

In Wednesday’s post, I’ll look at two other well-known investment experts who argue that high-yield corporate bonds should be part of a diversified portfolio.

{ 19 comments… read them below or add one }

Slacker October 4, 2010 at 12:17 pm

Very timely. Thanks !!

DM October 5, 2010 at 10:15 am

In my portfolio I have a 5% allocation to high yield bonds. As the Canadian ones you mention are very thinly traded, I decided to use JNK, one of the most widely traded high yield ETFs in the US. However, as I get hit every month on FX fees (particularly at my broker, Scotia iTrade), and given the positive correlation b/t high yield bonds and stocks, I’m wondering about the continued wisdom of keeping this position. As it stands now my plan is to slowly wind down my position in JNK as I approach retirement. One clearly doesn’t want to be involved with high yield bonds (or USD denominated ETFs of any kind, for that matter) in retirement.

Canadian Couch Potato October 5, 2010 at 4:02 pm

@DM: Why do you want to completely avoid all US-denominated ETFs in retirement?

DM October 5, 2010 at 7:41 pm

@CCP: I figure that at that stage of my life I won’t want to be exposing myself to currency risk. I plan to retire in Canada and all of my expenses will be in Canadian dollars. I don’t anticipate going cold turkey, though. I expect I will slowly wind down my USD denominated positions as (god willing) I move through my retirement.
I’m curious…do you thing there’s still place in a Canadian retiree’s portfolio for ETFs such as VTI, VEA and VWO (the ones I hold)?

Canadian Couch Potato October 6, 2010 at 10:22 am

@DM: These are great questions. I agree that you always want to reduce risk in your portfolio as you reach retirement, even if that means accepting slightly lower returns, so adding currency hedging to your international investments as you get older seems reasonable enough. It’s important to remember, however, that VEA and VWO do not expose you to the US dollar, as their underlying securities are held in their native currencies.

I’ll also share this quote from an interview I did a while back with Norbert Schlenker of Libra Investment Management: “Even if people think they aren’t going to do a lot of traveling outside of the country when they are retired, they still have to worry about the cost of imported goods. You may not care about the price of a hotel room in Phoenix, but you will still care about the price of orange juice, or a gallon of paint, or the price of gasoline, because those things are not priced in Canadian dollars. They are typically priced in US dollars. So you can’t simply dismiss what is going to happen to the foreign exchange value of the Canadian dollar, even if you expect to stay in Canada and spend all of your money here. It’s just not that insular of a place. Unless you’re living on a patch of ground and growing your own food you still have exposure to things that are priced outside Canada, so you should have some investments outside Canada.”

DM October 7, 2010 at 4:55 pm

@CCP, thanks for your reply, Dan. I’m a big believer in not taking more risk than I have to. I don’t know if I’ll hold any international investments in my retirement, actually. Thanks for pointing our currency risk of VEA and VWO – even though I can’t quite figure it out, I realize I’m exposed here to the underlying native currencies. thanks again!

Canadian Couch Potato October 7, 2010 at 6:29 pm

@DM: Yeah, it took my a while to get my head around this point, too! Have a look at these posts by Canadian Capitalist and Canadian Financial DIY, which help explain:
http://www.canadiancapitalist.com/reader-query-on-currency-risk-in-international-equities/
http://canadianfinancialdiy.blogspot.com/2007/05/clarification-of-foreign-exchange-risk.html

As you know, you could just use XSP and XIN to eliminate currency risk on US and int’l developed stocks in retirement, but there is no way way to hedge emerging market currencies in VWO.

anne marie October 8, 2010 at 10:43 am

Just wondering about the risk of US estate taxes on US ETF’s. As one gets older, would it not make sense to switch out of VTI and VEA into XSP and XIN simply to eliminate the worry of US estate taxes?

Canadian Couch Potato October 8, 2010 at 11:02 am

@Anne Marie: Yes, this is definitely an issue, although it only applies to the very wealthy. The estate tax laws have changed quite a bit, so if investors have at least $1 million or so in US-listed ETFs, they should talk to a tax specialist to make sure they’re not vulnerable. Much better to pay higher MERs than to get slapped with a huge death tax.

BadCaleb October 8, 2010 at 5:55 pm

I have about 5% of my portfolio in PH&N High Yield Bond Fund. It’s slightly more expensive for active management but for this type of investment, I’ll pay up. The fund is closing soon to limit the growth of the fund. The same manager is staying on so I am happy about that and I’ll continue to hold.

Andrew Hallam October 11, 2010 at 10:10 am

I read a study by Burton Malkiel that suggested diversified baskets of junks (like an ETF) give higher overall returns than investment grade bonds over the long haul.
But there’s always something funny about data like this. You and I discussed emerging market equities—and there are reports suggesting that over the long term, they have beaten developed markets and there are reports suggesting that when reinvesting dividends in both cases, the developed markets come out on top. So much is dependent on the starting and ending point, isn’t it? Who knows? I certainly don’t. But I don’t have any junk bonds in my portfolio—I’m too much of an investment wimp.

mike macdonald October 12, 2010 at 2:10 pm

A couple of comments: When looking at investment strategies such as junk bonds (which is what high yeild bonds are) it is wise to limit your portfolio to a maximum 10% “alternative style assets” ; and then within that constraint, each category of alternative assets to a 5% portfolio maximum. As an example a 5% allocation to junk bonds and 5% to bullion would cover the maximum 10% alternative investments for a portfolio.
Foreign Equities: People often talk about lowering risk by not holding international investments. In fact you will likly have higher risk if you choose not to hold some foreign investments due to reduced diversification.

Jamie February 8, 2013 at 12:55 pm

Thanks for this post.
Is there a difference in the tax treatment of bonds from US corporation (XHY) and Canadian corporations (XHB) when held within an RRSP?

Canadian Couch Potato February 8, 2013 at 1:18 pm

@Jamie: The tax treatment should be the same. In terms of income tax it makes no difference: all taxes are deferred in the RRSP until withdrawal, and then all of it is fully taxable upon withdrawal. And there is no longer a withholding tax on US bond interest. See this article from the Globe from 2010:

Following recent changes to the Canada-U.S. tax treaty, there is no longer any withholding tax on U.S. interest paid to Canadian investors. This is true regardless of whether the security is held in a non-registered account, RRSP, RRIF, LIRA, RESP or TFSA, said Brian Quinlan, partner at Campbell Lawless Professional Corporation chartered accountants in Toronto.

As always, check everything with a tax adviser before making any significant moves, as rules may have changed.

Ivan May 17, 2013 at 9:06 pm

Looking for more Canadian High Yield Bond ETF choices apart from the one mentioned above…Anyone know any other ETF where the holdings are majority in Canadian High Yield Bonds?

Canadian Couch Potato May 18, 2013 at 11:47 am
Ivan May 18, 2013 at 2:18 pm

Thank you Couch Potato!!!!
I can only see the top holdings of the above mentioned and will purchase this for montly distributions within my rrsp and outside of it.
What percentage of the above do you beleive is invested in Canadian high yield bonds?… I can only see the top holdings.

Canadian Couch Potato May 18, 2013 at 5:02 pm

@Ivan: Actively managed funds tend not to disclose all of their holdings the way index funds do. For more information on this ETF, I suggest contact Horizons directly.

Ivan May 18, 2013 at 8:38 pm

Thank you once again!!!! I want more diversification within fixed income high yield within my rrsp and I beleive this ETF along with a few others offer this …I will e follwing your website more accurately from now on.

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