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Future History of High Yield Bond Funds - Part II

The Future History of High Yield Bond Funds – Part II          05/30/2011
This report examines historical total returns of four high yield bond funds from major fund families as proxy for the entire sector. Three of the four high yield bond funds began in 1989-1990 with the fourth starting in 1996. The Vanguard fund (MUTF:VWEHX) started in July 1989 followed by both TRowe Price (MUTF:PRHYX) and Fidelity (MUTF:FAGIX) in September 1990. The Janus fund (MUTF:JAHYX) didn’t start until June 1996. All four have followed a similar NAV path over the years although the Fidelity fund (FAGIX) is far more volatile than any of the others. The similar performance is of course unremarkable since each fund operates in the same high yield bond sector albeit with differing guidelines. It is expected that the high yield ETF’s now in the market will also follow similar performance patterns.
This particular report looks at the rolling 3 year total returns of the four funds plotted against the returns from the 10 year Treasury Note. The TNote is presumed to be held at par value so its return is the yield. Obviously one could trade the TNote but that is not the purpose here.
Chart of rolling 3 year total return versus 10 year TNote
The Vanguard (VWEHX) fund had an average 3 year return of 7.1% over the period July 1992 through April 2011. Likewise the TRowe Price (PRHYX) fund had an average return of 7.3% over the period September 1993 through April 2011. The Fidelity fund (FAGIX) return over the same 9/1993-4/2011 period was significantly higher at 9.3%. The higher volatility is clearly rewarded. The Janus fund (JAHYX) with substantially fewer 3 year rolling periods – June 1999 through April 2011 – had an average return of only 5.3% which largely reflects the downtrend of returns over the 1989-2011 period.
In fact looking at only the period of January 2000 through December 2010 shows all four funds having much closer average returns: VWEHX 4.2%; PRHYX 5.4%; FAGIX 6.6%; and JAHYX 5.1%. The only time any of the funds approaches a double digit annual 3 year total return is the limited period of buying at a recessionary bottom and holding the fund during a subsequent rally. Worse, there have only been two significant periods of improving gains: from the 2000/2001 recession low to the 2005/2006 peak and again from the 2008/2009 recession low to the current peak. Other than far more modest rallies the general trend of all funds has been for declining total returns.
Why examine the historical results of high yield funds? Because economic history will likely repeat (or at least rhyme). The question for me as an investor is will I get a return that compensates for my perceived risk? Given the average returns over the past decade, the historical record and my current economic expectations the answer is only if I buy at recession lows. At almost any other point when the economy has recovered from a recession the returns trend lower. On the other hand, one might surmise that if the economy expands enough to end ZIRP (zero interest rate policy) and overall interest rates rise that the total return could also rise. This is counter-intuitive but the historical record suggests just such a scenario. An expanding economy means fewer defaults (lower risk premium) but rising interest rates suggests greater proportional rises in high yield debt. The net result may in fact be rising total return.
For my portfolio however I choose high quality, high dividend equities over the high yield bond space. Given the same positive scenario those stocks are likely to appreciate far more than high yield bonds. And, current dividends of 5%-7% challenge the high yield distributions. I also believe the stocks will not be any more volatile (and possibly a bit less) than the bond funds.