Factors In Practice: High-Yield Debt In Retirement?

by: Eric @ SERVO

Summary

High-yielding bonds seem attractive to retirees because of their perceived safety (they're bonds) and high interest payments.

The reality is that high-yield (or "junk") bonds have high risk for their paltry returns above investment grade bonds and perform like stocks during bad times.

Some combination of a diversified stock portfolio and high-quality bonds are almost always a superior approach to achieving ongoing cash flow, especially net of taxes and estate considerations.

In the first of an ongoing series I call "Factors in Practice," where I'll answer readers' questions about retirement-related investment topics, I cover a question about high-yield debt for income from Bill CNY:

I'm becoming interested in learning about investing in distressed debt as a way to enhance retirement income. Does this sound like an oxymoron? It's clearly a high risk/reward arena but perhaps there are diversification and hedging strategies to mitigate the risks. I have not seen any articles on SA on this topic. Hoping to learn more."

I have to imagine the motivation for Bill's question comes from the idea that cash flow in retirement is most easily attained from sources that provide a regular and transparent dividend or coupon payment that can be "clipped" for spending purposes, as opposed to having to sell shares of securities periodically. After all, if you have, say $1M and need $50K per year, what's easier than buying a portfolio of bonds/bond mutual funds that yield 5% (and, of course, the same logic applies to the ever-popular dividend-stock approach)? Arguably, a bond solution would be even better given their additional safety in the event of company or economy-wide distress (bond holders have a senior claim on assets). I call this "bird-in-the-hand" investing, as retirees often prefer and will even pay a premium for investments that pay them directly as opposed to having to generate the cash flow themselves.

So let's look at high-yielding, or distressed-debt investing in the context of the universe of available investment options.

Asset Class

1984-2015 Return

Risk

2008 Return

S&P 500 Index

+10.9%

15.1

-37.0%

Global Stock Index

+12.7%

15.2

-41.7%

Barclay's Govt. Bond Index

+6.5%

3.4

+10.4%

Barclay's AAA Bond Index

+6.9%

3.5

+7.9%

Barclay's AA Bond Index

+7.2%

3.9

+1.6%

Barclay's A Bond Index

+7.4%

4.4

-4.9%

Barclay's BBB Bond Index

+7.9%

4.6

-8.4%

Barclay's High-Yield Index

+8.4%

8.1

-25.5%

Click to enlarge

Barclay's produces a "high-yield composite" index with data back to 1984, which covers what can reasonably be considered distressed debt bonds whose ratings are below "investment grade" of BB, B and into the Cs. The chart above lists the returns of the high-yield index along with the various rungs of the investment-grade bond universe, U.S. stocks and a globally-diversified stock portfolio.

First, the results. In the bond market, we find that returns line up with associated risk - government bonds have the lowest risk and have generated the lowest returns, +6.5% per year. +0.4% per year more was had from holding the highest-rated AAA corporate bonds, +0.3% more for AA-rated bonds, +0.2% more for A and +0.5% for the bottom rung of the investment grade spectrum, BBB. High yield, or distressed debt, generated a return of +0.5% per year more than BBB-rated bonds.

The relative risk is a bit more lumpy. Volatility rises gradually from government to BBB-rated bonds, and then almost doubles at the high-yield level. So, at first glance, it doesn't look like the small additional return from high-yield bonds is warranted by their additional risk. This becomes even more apparent when we see that stocks (S&P 500 Index) earned almost 11% per year - high-risk too, but it took only a small amount of stock exposure to match the minimal uptick in returns from high-yield bonds over safer investment grade debt. Looking at the globally-diversified stock portfolio, we see this effect is even more pronounced - it outperformed high-yield bonds by over 4% per year, with similar risk as the S&P 500.

Here we reach our first conclusion: that returns in general, and specifically returns higher than the safest bonds, are more easily and consistently achieved by adding (at least) small amounts of a globally-diversified stock portfolio to higher-quality bonds.

Up until now, we've only considered long-term volatility as our metric for "risk." But what about our portfolio's behavior in bad times? When you're retired, you can't take an income "time out" while you wait for capital markets to recover; your cash flow must continue.

The column labeled "2008" shows the issue with high yield or distressed debt under this consideration. We know stocks got hammered in 2008, it was the worst calendar year since 1937 (which is to say, don't expect this result every few years!). But did you know that high-yield bonds performed almost as poorly? The high-yield bond index lost almost 26% that year. Sure, not every issuer eliminated their interest payments, and bond prices rebounded the next year (as did stocks), but psychologically you have to ask yourself: how comfortable would you have been spending what was left of your interest payments as your entire principal declined by over 1/4 (the decline includes price depreciation and interest payments)?

What if you held several years of your income in high-quality bonds - government, AAA and AA rated securities? They actually gained 10%, 8% and 2%, respectively. How much easier would it have been to "stay the course" knowing you had ample reserves to ride out the storm and wait for your stock portfolio to recover, as it always has? My guess is, and personal experience with clients tells me, this would have been much easier.

Finally, no discussion of high yield or distressed-debt investing would be complete without a few of the practical considerations investors face.

First, I'm using a costless index to represent "distressed debt." It's not at all clear that real-world investors could actually achieve these results. In 2015, renowned distressed-debt investor Marty Whitman was ousted from his own company after the implosion of a mutual fund they managed focusing on distressed debt. I can tell you, for Third Avenue Focused Credit shareholders, the results of the Barclays index vastly overstates their actual experience, which saw 2008-like (stock) declines last fall. I'm not entirely sure today, in the midst of reorganization, if Focused Credit shareholders have even received their money back. Or what's left of it. Stocks, on the other hand, are again reaching all-time highs as they wait - an important lesson, I believe.

But maybe you aren't thinking about buying bonds (or a fund) with that much distress. The Vanguard High-Yield Corporate fund VWEHX, VWEAX, JNK) is a well-known strategy that yield chasers are fond of. It tends to stick with the highest-rated (B and BB) high-yield bonds (now that's an oxymoron). Unfortunately, its returns of +7.9% per year from 1984-2015 only match the returns of the BBB-rated investment grade index (which had much less risk), and almost 5% per year worse than our global stock portfolio. So at best, it seems, distressed-debt investors have put up with most of the risk inherent from a diversified stock portfolio and been rewarded only with investment grade-like returns. Not great. And I think it gets worse.

No investment discussion is complete without mentioning taxes. With stocks, most of the return comes from appreciation, with some dividends thrown in. Qualified dividends and sales of shares held longer than one year are taxed at long-term capital gains rates. Not so with bonds (ex. munis), whose interest payments are considered ordinary income. The highest-yielding bonds, then, represent what is one of the most tax-inefficient asset classes imaginable. Some combination of lower-yielding (and safer) bonds and tax-efficient equities will most assuredly provide even better results on an after-tax basis. Throw in the fact that you can "locate" bonds in IRAs (which also serves to reduce future RMDs and future taxes due to relatively low returns and stunted IRA growth) and stocks in taxable accounts (which may qualify for a stepped-up basis upon death if not spent) and you'll see that your CPA will be thrilled and you'll have the initial draft of an excellent legacy plan as well.

Of course, I've not said anything about how you would go about taking income from a stock and bond portfolio which does not, on the surface, "pay out" enough in dividends and interest to cover modest (say 5%) annual cash flow needs. Fear not, I won't go on any longer as I just wrote an entire article on the subject (read it here). And if you're sufficiently ambitious as to want to compare results over the period I mentioned in the article between the "total return" approach and the "distressed debt" version, know that you'd have about $860,000 left in high-yield bonds by year-end 2015, about a $500,000 shortfall (and far less if you chose wrong and went with a Whitman-like portfolio) - see here. What's worse, we all know high-yield bond yields are nowhere near where they were in 2000, which brings into question how much the historical returns on distressed debt even matter.

All this is to say, don't do distressed debt. The yields can be enticing in a world where interest is scarce; but remember, where there's the opportunity for reward, there lies risk. And the risk of high-yield bonds - significant illiquidity, poor returns during economic declines, high costs that overstate index returns relative to realized results, not to mention the poor tax treatment - renders them inappropriate for individual investors with serious long-term goals. The good news is, there are alternatives to generating a sizable and growing income stream; it just requires a bit more manual labor.

__________________________________________

Source of data: DFA Returns 2.0

Global Stock Index = DFA Equity Balanced Strategy Index (details available upon request)

Past performance is not a guarantee of future results. Index and mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

Disclosure: I/we 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.