HY Bonds = High or Hazardous Yield?

SUMMARY

• The correlation of high yield (HY) to investment-grade (IG) bonds has been increasing
• HY bonds can simply be replicated via a combination of the S&P 500 and IG bonds
• Replication portfolios offer better Sharpe ratios, which makes a case against using HY bonds in asset allocation

INTRODUCTION

When we recently ran a peer review analysis for BlackRock’s 60/40 Target Allocation Fund (BIGPX) using our automated Fund Reviewer tool, then the list of ETF peers did not only include similar cross-asset allocation funds, but also high yield funds like Fidelity’s High Yield Factor ETF (FDHY) and iShares’ iBoxx $ High Yield Corporate Bond ETF (HYG).

Our initial reaction was that the algorithmic peer selection process was poor, but upon further reflection, this assessment might be correct. After all, high yield bonds sit somewhere between equity and debt in the capital structure of companies. Given that a 60/40 portfolio represents a combination of equity and debt securities, this might be equivalent to a high yield bond portfolio.

However, this implies that high yield bonds provide negative diversification benefits as they increase the equity and debt exposures, which makes them structurally unattractive for a diversified portfolio.

In this research article, we will review the use of high yield bonds within asset allocation.

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