Portfolio Investing Blog: Portfolioist

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.

 (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: 

 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: 

 (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: 

 (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:

• The Biggest Unknown in Financial Planning
• Beyond VIX: The Outlook for Market Risk
• The Big Retirement Downshift: From Saving Up to Drawing Down

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