Chasing Yield: Is the Flow of Money into Munis and High Yield Bonds Rational?

There has been a steady flow of money into junk bonds and municipal bonds over the last several months.  In fact, we have had a string of eighteen weeks with increases in mutual funds assets that invest in high-yield bonds and munis.

There is also evidence of money flowing into ETFs that focus on preferred shares. The ETF Industry Association reports that two high-yield bond ETFs were included in their list of the ETFs with the highest inflows for the year-to-date (Note: readers can access data on ETF inflows and outflows here). 

 What I want to know is: Are these flows simply evidence of investors chasing yield?The flow of money into these asset classes is clearly driven by their yield. The iShares iBoxx High-Yield Corporate Bond fund (HYG), yields 7.36% and the iShares S&P Preferred Stock Index (PFF) yields 6.04%. Now, munis have a much lower yield, but my sense is that people perceive munis as a “safe” way to boost yield. The iShares S&P National Municipal Bond Fund (MUB) has a yield of 3.2%.  The Powershares National Insured Municipal Bond ETF (PZA) has a current yield of 4.36%.  The yields on munis are considerably higher than the current 10-year Treasury yield at 2.02%. 

 The standard criticism of the flow of money into these asset classes (high-yield bonds in particular) is that investors are simply chasing yield and are not properly accounting for the increased risks of these higher-yield asset classes. This is probably a fair assertion.  What measures might be used to compare risk levels among these asset classes?

Quantifying the Yield vs. Risk Trade-Off

The table below shows the trailing 3-year volatility, a standard measure of risk, as calculated by Morningstar.  Because the trailing three-year period does not include the very big market swings of 2008, I have also included my own results for trailing 4-year volatility. In addition, I have included Monte Carlo simulations for risk levels on a going-forward basis.  The table also shows current yields.

Name:

Ticker:

Yield:

Trailing 3-Year Volatility from Morningstar.com:

Trailing 4-Year Volatility Through March 2012

Source: Author

Projected Volatility from Monte Carlo

Source: Author

iShares S&P Preferred Shares

PFF

6.04%

15.1%

29.0%

29.0%

iShares iBoxx High-Yield Bond

HYG

7.36%

11.7%

17.7%

15.5%

iShares National AMT-Free Muni

MUB

3.21%

5.5%

6.1%

9.0%

iShares Insured National Muni

PZA

4.36%

6.9%

7.4%

10.4%

iShares 7-10 Year Treasury

IEF

2.41%

8.1%

8.1%

10.9%

iShares Corporate Bond

LQD

4.23%

6.8%

11.1%

9.6%

iShares Aggregate Bond

AGG

2.75%

4.3%

4.9%

4.6%

iShares 1-3 Year Treasury

SHY

0.69%

1.4%

1.4%

1.6%

 (Source: etrade.com.)

Taking a Rational Look at Risk vs. Return

When add the additional risk information, we can rationally look at the yield vs. risk provided by each of these asset classes. To further simplify, we might start by looking at the ratio of yield to risk for each of these, and ranking them according to each risk level. 

 In the table below, I show the ranking of yield / risk: 

   

Rank of Yield/Risk:

 

Name:

Ticker:

Trailing 3-Year Risk:

Trailing 4-Year Risk:

Monte Carlo Risk:

iShares S&P Preferred Shares

PFF

7

8

8

iShares iBoxx High-Yield Bond

HYG

3

5

2

iShares National AMT-Free Muni

MUB

5

3

6

iShares Insured National Muni

PZA

2

1

5

iShares 7-10 Year Treasury

IEF

8

7

7

iShares Corporate Bond

LQD

4

6

3

iShares Aggregate Bond

AGG

1

2

1

iShares 1-3 Year Treasury

SHY

6

4

4

 Ranking of Yield/Risk Ratio (1=highest, 8=lowest.)

It should not be surprising that the aggregate bond index, AGG, looks most attractive on a stand-alone basis because it has the benefit of diversification across a number of fixed income classes. Preferred shares, despite having a substantial yield, look unattractive on a standalone basis. The intermediate-term Treasury fund (IEF) looks quite unattractive as well.  The Insured National Muni fund (PZA) is the second most-attractive asset class on a standalone basis and the High-Yield Bond fund is the third. 

The individual risk/yield ratios are of interest, but they are not the ultimate measure.  I ran an optimization using the Monte Carlo simulation results. The goal of the optimization was to create a portfolio with maximum yield for a risk level no higher than the risk level of the aggregate bond index (AGG). AGG has a yield of 2.75%. The optimized portfolio has a yield of 4.6% and risk equal to that of AGG.  The components are shown below: 

Asset Class

Ticker

Weight

High Yield Bonds

HYG

37.9%

Intermediate Term Treasuries

IEF

35.7%

National Insured Munis

PZA

17.0%

Aggregate Bond Index

AGG

9.4%

 (Optimized yield portfolio with projected risk equal to AGG.)

The Surprising Results

 The results above may surprise some readers.  If Treasuries are so unattractive, why do they comprise almost 36% of this portfolio?  The answer lies in the correlations between these asset classes. Treasury bonds are contributing risk mitigation due to their very low correlation to high-yield bonds. Granted, this result is driven by the forward-looking projections. To stress test this result, I ran the optimization using trailing 4-year volatility rather than projected volatility, with the same goal of maximizing yield, but with the constraint that trailing 4-year risk of this portfolio could be no more than that of AGG.  The resulting portfolio, with a yield of 3.47%, is shown below: 

Asset Class

Ticker

Weight

National Insured Munis

PZA

42.5%

Aggregate Bond Index

AGG

33.3%

Short Term Treasuries

SHY

14.7%

High Yield Bonds

HYG

7.6%

Intermediate Term Treasuries

IEF

1.9%

 (Optimized yield portfolio with trailing 4-year risk equal to AGG.)

Because of the substantial increase in correlations between asset classes during the big market declines in 2008, the portfolio optimized using historical 4-year risk depends more on municipal bonds and less on high-yield bonds. There remains, however, a meaningful allocation to high-yield. 

Shedding a Different Light on Munis and High Yield

The results above shed a different light on the relative attractiveness of municipal bonds and high-yield bonds for income investors. Using various measures of risk, it seems perfectly rational for investors to hold meaningful allocations to high-yield bonds and muni bonds.  For those with higher risk tolerance, it may make sense for income-oriented investors to consider replacing some portion of their equity portfolios with high-yield bonds. 

It is entirely possible—even probable—that many investors are adding allocations to high-yield bonds and muni bonds without properly weighing the risks. As my calculations show, high-yield bonds and muni bonds are markedly riskier than an aggregate bond fund. 

 Investors who ignore the spread in risk are making a big mistake.  For those who account for the risk differences, there are still good reasons to hold high-yield and muni bonds.  Default rates in the high-yield space are low and a number of analysts expect them to remain low

The same is true for munis.

Related Links:

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About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for Aquila Energy. Leaving Aquila in 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002. Geoff has published commentary and analysis in a range of publications, including Advisor Perspectives, Financial-Planning.com, and Horsesmouth.com. Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com (http://www.foliofn.com)). Neither Quantext nor Geoff Considine is an investment advisor.

3 thoughts on “Chasing Yield: Is the Flow of Money into Munis and High Yield Bonds Rational?

  1. Elliot Royce

    Dont really get it: your analysis shows that munis have a lower volatility than med term risk free assets with a higher return. Why lump them with junk bonds?

  2. mlonier

    Interesting that LQD, a relatively steady all-weather performer (ranks 3 in the forward projection) drops out of the optimized set, much like other bar-bell designed risk-adjusted portfolios, like Swedroes’s 1/3 small cap valu, 2/3 TIPs or T-bills. Makes sense statistically, cranking return against risk, but intuitively seems to be reducing diversification as well as cutting out valuable preferred asset class. The problem with modeling PFF versus holding diversified preferred issues is that the study treats PFF like a risky variable price security (which it is) while well-rated cumulative preferreds held perpetually can provide yield at 6.5%+. Putting those in as a floor under a risk adjusted portfolio can raise the over all yield with some presumably smaller risk factor to account for potential defaults.

  3. Pingback: Stocks and Shocks: What to Do? « Portfolio Investing Blog: Portfolioist

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