The Surprising Risk-Return Profile Of Junk Bonds

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Includes: VFICX, VFSTX, VWEHX, VWESX
by: Dane Van Domelen

Summary

Junk bonds carry high interest rates to offset a perceived high risk of default.

Compared to investment-grade bonds, you might expect higher raw returns, but worse risk-adjusted returns (the usual trend).

In fact, Vanguard’s VWEHX has a very favorable risk-return profile relative to its investment-grade funds.

Since Oct. 1993, annualized growth is comparable to the long-term investment-grade fund VWESX (6.4% vs. 6.9%), but Sharpe ratio is drastically better (0.088 vs. 0.047).

Caveats: (1) Relatively high drawdown risk; (2) weak positive correlation with equities.

Junk bonds

Sometimes when my dad asks me about my retirement savings, I'll mess with him and say that it's all in junk bonds. It sounds like a terrible idea: lending a substantial amount of money to companies that have such a high perceived risk of default that they have to promise a very high interest rate.

Compared to higher rated (i.e. investment-grade) bonds, you would have to assume that junk bonds would exhibit worse risk-adjusted returns. For most types of investments, that's certainly the case. The only way to go for higher returns is to take on disproportionately higher risk.

To illustrate, if some investment, fund, or strategy A averages greater raw returns and greater risk-adjusted returns than another investment B, B is essentially obsolete. You can just combine investment A with cash to lock in the better risk-adjusted returns, scaled down to whatever level of risk you prefer. There would be no benefit to choosing B over A.

Interestingly, in the case of corporate bonds, there does not appear to be a tendency for junk bonds to have worse risk-adjusted returns than investment grade bonds. In this article, I highlight how Vanguard's junk bond mutual fund has actually generated much better risk-adjusted returns than several of its "safer" investment-grade bond funds.

Vanguard mutual funds

Table 1 shows basic characteristics of five Vanguard mutual funds. The first three are investment-grade corporate bond funds, ranging from short to long duration; the fourth is Vanguard's high-yield mutual fund; and the last is its S&P 500 index fund, included as a reference.

Table 1. Characteristics of select Vanguard mutual funds.
Ticker Fund Inception Expense ratio Total net assets SEC yield
VFSTX Vanguard Short-Term Investment-Grade Fund Investor Shares Oct. 29, 1982 0.20% $58.1B 1.92%
VFICX Vanguard Intermediate-Term Investment-Grade Fund Investor Shares Nov. 1, 1993 0.20% $27.8B 2.71%
VWESX Vanguard Long-Term Investment-Grade Fund Investor Shares July 9, 1973 0.21% $14.4B 3.99%
VWEHX Vanguard High-Yield Corporate Fund Investor Shares Dec. 27, 1978 0.23% $21.8B 4.75%
VFINX Vanguard 500 Index Fund Investor Shares Aug. 31, 1976 0.16% $292.4B 1.87%

Performance since 1993

Figure 1 shows growth of $10k in each fund over their mutual lifetimes. Performance metrics are summarized in Table 2.

Figure 1. Growth of $10k in select Vanguard mutual funds from Oct. 29, 1993, to March 13, 2017.

Table 2. Performance metrics for Vanguard mutual funds from Oct. 29, 1993, to March 13, 2017.
Ticker Annualized growth Maximum drawdown Sharpe ratio
VFSTX 4.4% 8.3% 0.113
VFICX 5.8% 14.3% 0.072
VWESX 6.9% 17.8% 0.047
VWEHX 6.4% 30.2% 0.088
VFINX 9.2% 55.3% 0.036

All four bond funds had worse raw returns, but better risk-adjusted returns, than the S&P 500. Within the investment-grade funds, there was the expected relationship between raw and risk-adjusted growth: Longer duration -> higher raw returns -> lower risk-adjusted returns.

Surprisingly, the high-yield fund VWEHX had a better Sharpe ratio than both the intermediate- and long-term investment-grade funds.

Let's take a closer look at the return and risk components of the Sharpe ratio. Figure 2 shows mean vs. standard deviation of daily gains for the five funds.

Figure 2. Mean vs. standard deviation of daily gains for select Vanguard mutual funds from Oct. 29, 1993, to March 13, 2017.

Again, it comes as a big surprise to me that over a 23+ year period VWEHX has actually been less volatile than the intermediate- and long-term investment-grade funds VFICX and VWESX. You probably wouldn't say VWEHX is "lower risk" than the other two funds considering its much higher MDD (30.2% vs. 14.3% and 17.8%), but it is less volatile.

Vanguard's Product summary for VWEHX states that "...high-yield bonds tend to have volatility similar to that of the stock market." In fact, using standard deviation of daily gains as a measure of volatility, VWEHX's volatility has been less than one-fourth that of VFINX's over the time period analyzed in this article.

Except for VWEHX, things appear relatively normal in Figure 2. If you can handle the volatility of VFINX, it provides the highest expected returns. You could combine VFINX with cash to move along the dotted line connecting it to the origin; eventually, you're better off switching to VWESX, as it provides better expected returns for a given level of volatility. Move along VWESX's dotted line towards the origin, and eventually you're better off with VFICX, and finally with VFSTX.

VWEHX sort of throws the picture off. First of all, notice that VWEHX dominates VFICX, in that there is no level of volatility for which VFICX offers higher expected returns. Second, there is only a small area where VWESX offers higher expected returns than VWEHX, and it comes at a cost of drastically higher volatility. For example, a 100% VWESX portfolio is 213% more volatile than 100% VWEHX, and comes with only 13% higher expected returns.

Positive correlation with equities

One important difference between VWEHX and the three investment-grade funds is that VWEHX has a weak positive correlation with the S&P 500, while the other three are all negatively correlated with the S&P 500 (Table 3).

Table 3. Correlation matrix for daily gains from Oct. 29, 1993, to March 13, 2017.
VFSTX VFICX VWESX VWEHX VFINX
VFSTX 1.00 0.86 0.68 0.48 -0.14
VFICX 1.00 0.88 0.39 -0.17
VWESX 1.00 0.28 -0.21
VWEHX 1.00 0.18
VFINX 1.00

Positive correlation with equities implies that VWEHX might not perform as well as the other three funds when paired with an S&P 500 fund like VFINX. Consider the risk-return profile of two-fund portfolios comprised of each fund with VFINX, shown in Figure 3.

Figure 3. Mean vs. standard deviation of two-fund portfolios comprised of VFINX and each bond fund, using data from Oct. 29, 1993, to March 13, 2017. Data points reflect 10% allocation increments.

The pronounced bend in the orange curve reflects VWESX's negative correlation with VFINX. There isn't such a strong bend in the purple VWEHX/VFINX curve. As a result, in the volatility range where all but the most conservative investors would be, VWESX pairs better with VFINX than VWEHX does.

VWEHX vs. other high-yield funds

The results so far are specific to Vanguard's high-yield fund, VWEHX. For a quick assessment of whether results are similar for other high-yield funds, I grabbed three funds from this list. Figure 4 shows mean vs. SD over the mutual lifetimes of these three funds and VWEHX (Jan. 12, 2011, to March 13, 2017), alongside the three investment-grade funds and VFINX.

Figure 4. Mean vs. standard deviation of daily gains for select mutual funds from Jan. 12, 2011, to March 13, 2017.

The four high-yield funds cluster together in roughly the same region. All are drastically less volatile than VFINX, and offer very appealing risk-reward compared to the investment-grade funds. Out of the four high-yield funds, PHYSX had the highest Sharpe ratio at 0.139, followed by VWEHX at 0.098, FIHBX at 0.096, and TIHYX at 0.086. All but TIHYX had higher Sharpe ratios than all three investment-grade funds.

Conclusions

You might expect relatively high raw returns from junk bonds, given their high interest rates. The main finding of this article is that junk bonds have a history of providing surprisingly strong risk-adjusted returns as well.

In Vanguard's case, over a 23+ year period, the high-yield fund VWEHX has had similar raw growth as the long-term investment-grade fund VWESX (6.4% vs. 6.8% CAGR), but with a drastically higher Sharpe ratio (0.088 vs. 0.047). It takes a very favorable high-and-left position on the mean-SD plot, offering a surprisingly high expected return for its volatility.

There are two caveats for VWEHX: (1) Its maximum drawdown, 30.2%, was much worse than the investment-grade funds; and (2) its weak positive correlation with equities renders the long-term VWESX generally better suited for a two-fund stocks and bonds portfolio.

Disclosure: I am/we are long VWEHX, VFINX.

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.

Additional disclosure: The author used Yahoo Finance to obtain historical stock prices and used R to analyze the data and generate figures. Any opinion, findings, and conclusions or recommendations expressed in this material are those of the author and do not necessarily reflect the views of the National Science Foundation.