Vanguard recently announced that it would be closing its high-yield corporate fund “effective immediately” and that the fund had received “approximately $2 billion” of flows over the past six months. While growth of Vanguard’s assets under management is almost always a good thing, a fund shuttering its doors to new flows makes one wonder just how frothy credit markets have become. Let’s take a step back, though, and look at high-yield bonds as an asset class. Many investors simply don’t understand the returns that high-yield bonds have historically generated or just how closely correlated they are with the equity markets.
Over the period 1970–2009, Moody’s reports that 21 percent of high-yield corporate bonds defaulted within a typical five-year period. This means that if you started with a portfolio of 100 high-yield corporate bonds, on average 21 of those would have defaulted after a five-year holding period. From the investor’s point of view, this means the return on investment would be substantially less than the yield of a portfolio of high-yield bonds.
We can gauge how much “slippage” there has been using data from Barclays Capital. Barclays reports that the yield advantage of high-yield corporate bonds compared with Treasury bonds of comparable maturity has been about 5.3 percent over the period January 1994–March 2012. This means that if Treasury bonds yielded 5 percent on average over this period then high-yield bonds yielded about
10.3 percent on average. Yet, the return advantage of high-yield corporate bonds relative to Treasury bonds has been about only 2 percent per year. So, investors lost roughly 60 percent of the yield advantage to defaults.