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The high yield bond market has been on a tear again this year as investors continue to scramble for yield anywhere they can find it. The average yield on a (not so) high yielding note has fallen to record lows recently of below 5%. High yielding bonds are a rather volatile asset class and losses experienced by holders of high yielding bonds in 2008 were nearly as severe as for investors in stocks. Vanguard's High Yielding Corporate Fund (MUTF:VWEHX) declined 21.3% compared to a 37% loss for the S&P 500 (Table 1). The table below also illustrates the diversification afforded to investors in Treasury bonds, which rallied 13.1% and 25.8% for 5 and 20-year notes respectively.

Table 1: Historical Returns of the S&P 500, High Yielding bonds and Treasuries in 2000-2002 and 2008 Bear Markets (click to enlarge)

(Click to enlarge)

It must also be remembered how anomalous the current yields on both high yielding bonds and Treasuries are historically. Since 1962, neither Treasuries nor high yielding bonds have enjoyed valuations higher than at the present time. While safe-haven bonds still serve the role of diversification and buffer the volatility of a portfolio by moving in the opposite direction of the market, high yielding bonds have questionable value given the current high prices. They serve neither to buffer a portfolio against the vagaries of the market, nor to provide income greatly in excess of what can be achieved by purchasing higher yielding dividend stocks. Conoco-Phillips (NYSE:COP) presently yields 4.24%, while AT&T (NYSE:T) yields 4.82%, Reynolds American (NYSE:RAI) yields 4.94% and The Southern Company (NYSE:SO) yields 4.40%. These yields are now becoming roughly comparable to those of high yielding bonds before considering loss of capital due to default.

Figure 1: Ten Year Treasury Rate and BAA Corporate Bond Yield Since 1962
(Click to enlarge)

The table below presents the average and current yield on a 10 Year Treasury note and a BAA rated corporate bond. While the spread is currently above its historical average compared to AAA rated corporate bonds the spread is near its all-time low.

Table 2: Historical Rates of Return for Various Bonds (click to enlarge)

(Click to enlarge)

The yield on AAA rated corporate debt has actually increased over the past month and presently yields 3.80%, so depending on the yard-stick one uses BBB rated debt can either be described as historically cheap relative to Treasuries or historically dear compared to higher rated corporate bonds. The BBB/AAA risk premium is shown in the figure below. Buying a BBB high yield bond presently yields 1.40% more than buying a AAA rated investment grade bond.

Figure 2: BBB Bond Risk Premium Compared to AAA Rated Corporate Debt (click to enlarge)
(Click to enlarge)

Finally it must be noted that these yields do not take into consideration the risk of default, while AAA rated debt yields 3.80% and BAA rated debt yields 4.59% the historical risk of default increases from less than 1% for a AAA bond at a 10 year time horizon to closer to 8% for a BAA rated bond in the same time frame. In other words, the extra 0.79% compensation for holding a BAA bond relative to a AAA bond is barely expected to exceed the increased likelihood of default at a ten-year time horizon (Table 2). Since higher rated debt is less volatile, reaching for yield at the present time is illogical as the expected long-term return is more or less the same. If the expected return for two assets is the same, one should always buy the safer less volatile asset. At some point in the future you may then have the opportunity to buy the more volatile asset for a lower price by selling the less volatile asset.

Figure 3: Historical Default Rates Among Differently Rated Corporate Debt from 1920 through 1996

At present, the momentum of the market still favors holders of high yielding credit. However, as presented above the valuation is now unquestionably very rich in historical terms. If you own lower rated corporate debt, selling to buy higher dividend paying stocks side-steps the issue of momentum as both risk assets will most likely move in the same direction. If instead you own bonds for their diversification, now is the time to consider moving toward a more risk-averse stance as it seems that the market is presently valuing higher yielding bonds at a very lofty premium. Thus, if you hold high yielding bonds via a vehicle such as Vanguard's High-Yield Corporate Fund (VWEHX), consider selling should the fund fail to hold its 50-day moving average.

Even at the current lofty prices bonds still have a place in a diversified portfolio. However, given these lofty valuations the purpose of holding bonds should be to limit volatility and have dry powder available to buy stocks at desirable prices rather than net much in the way of capital appreciation. If you want capital appreciation you must take risk and risk is presently better compensated in dividend paying stocks compared to high yielding bonds. If you are investing money for the long-term, sell high yield bonds and buy dividend paying stocks. If you are investing money you cannot afford to lose, sell high yielding bonds and buy safer investment grade corporate bonds, municipals or Treasuries.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: It Is Time To Sell (Not So) High Yielding Bonds