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High-Yield Bonds and Your Portfolio: Part 2

In Monday’s post, I discussed the growing popularity of high-yield bonds: four Canadian ETFs covering this asset class have appeared in the last 12 months. I explained how investment gurus Larry Swedroe and David Swensen both advise investors to avoid high-yield bonds and instead stick to safer fixed-income investments such as government bonds.

Not all portfolio managers agree with that assessment, however. Today we’ll look at two well-known index investors who believe that high-yield corporate bonds can play role in a diversified portfolio.

Richard Ferri’s All About Asset Allocation, now in its second edition, is one of my favourite books on this important subject. Ferri argues that high-yield bonds aren’t as highly correlated with equities as others believe. “Some market researchers suggest that default risk is nothing more than a type of equity risk,” Ferri writes, “and therefore adding high-yield corporate bonds to a portfolio is the equivalent of adding more equity. That argument is not entirely correct.”

Ferri explains that since the early 1980s, there have been periods where the default risk of high-yield bonds was highly correlated with equities, but also periods where the correlation was zero,

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High-Yield Bonds and Your Portfolio: Part 1

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.

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Mackenzie’s Fund Report Misses the Point

Ah, the good people at Mackenzie Financial. Last year, they brought us I Thought I Wanted an ETF, a marketing brochure full of red herrings and half-truths about exchange-traded funds, clearly designed to discourage their clients from getting out of Mackenzie’s high-priced dreck and into low-cost investments. You can read discussions of this little gem on Larry MacDonald’s and Jon Chevreau’s blogs.

Now the consumer advocates at Mackenzie have released a new report called Canadian Mutual Fund Ownership Costs: Competitive Relative to the U.S. It looks to bust the popular idea that US investors pay dramatically lower fund fees than Canadians. You can download either the six-page research summary or the complete 14-page report. If you have a pronounced gag reflex, I suggest the briefer version.

Fees are calculated differently

I’ll concede that several points highlighted in the report are true, and that they’re often misunderstood by investors and the media, who tend to focus on Canada’s undeniably higher MERs. “The calculation of mutual fund expenses is different between the two countries,” the report rightly argues,

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9 Secrets of the Empowered Investor, Part 2

This post is the second of three that outline nine critical factors in investment success, as identified by Keith Matthews, a portfolio manager with Tulett, Matthews & Associates in Montreal.

4. Value and small stocks outperform over time.

Many investors look for opportunities in growth companies. But long-term data show that investments in value companies (which have low price-to-book ratios, and are often out of favor) have produced higher returns than growth companies. Small companies have also produced higher returns than larger, more well-known companies.  These premiums appear to exist in all parts of the world.

These observations were reported by finance professors Eugene Fama and Kenneth French in the early 1990s. They explained that investors perceive higher risk in value and small companies and, accordingly, their stocks should provide higher expected returns. This is consistent with the notion that markets are efficient.

Portfolios that are “tilted” toward value and small-cap stocks add more risk, and therefore should have higher expected returns than the broad-market indices over the long term.

5. Markets move randomly and unpredictably.

The chart below ranks the best and worst performing asset classes each year from 2000 through 2008.

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Indexing’s Dirty Little Secret

“Most actively managed mutual funds underperform the market.” Couch Potato investors sing this refrain all the time in defense of ETFs and index funds. I’ve done it many times myself — a bit smugly, I confess. My FAQ page points out triumphantly that 92.6% of actively managed Canadian equity funds have trailed the S&P/TSX Composite over the last five years, according to Standard & Poor’s, which issues a quarterly report on active funds versus the indexes.

But here’s the part that S&P and most indexing advocates usually leave out: the vast majority of ETFs and index fund underperform their benchmarks, too. So it’s not fair for index investors to imply that they earn market returns, because they almost never do. Call it indexing’s dirty little secret.

This inconvenient truth is discussed in an excellent article by Scott Ronalds, published in this month’s Canadian Money Saver. Ronalds is manager of research and communications with Steadyhand Investment Funds. His article doesn’t disparage indexing, nor does he pull out the red herrings that Mackenzie Financial and others use to criticize ETFs. He simply points out that a true apples-to-apples comparison would pit actively managed funds against ETFs and index funds in the real world,

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How Much Risk Do You Need to Take?

Every book on index investing stresses the importance of asset allocation: the percentage of equities and fixed-income investments in a portfolio. Of course, more stocks means more risk but higher expected returns, while boring old bonds provide safety and promise less growth. But just what is the long-term difference in risk and returns between stocks and bonds? How does a 50-50 portfolio compare with one that holds just 20% bonds, or 20% equities?

Paul Merriman, who runs the Seattle-based investment firm that bears his name, recently wrote an article that included a table of historical stock and bond returns going back to 1970. It compares the performance and risk of portfolios with various stock-bond mixes. The returns are hypothetical, but they represent a reasonable estimate of what you might expect from a portfolio of low-cost index funds that track the broad markets.

Merriman assumes that the equity portion of each portfolio is split equally between the S&P 500 and international stocks, and the fixed income side is half intermediate-term, 30% short-term and 20% inflation-protected Treasuries. They also deduct a 1% management fee and assume the portfolio is rebalanced monthly. Here’s a summary of the results:

Annualized return
Standard deviation
Worst 12 months
Worst 60 months

100% fixed income

10% equities

20% equities

30% equities

40% equities


60% equities

70% equities

80% equities

90% equities

100% equities

There are a couple of lessons in these numbers.

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