Riskier High-Yield Bond Funds Underperform Their P

Since last October, as default rates started to decline, high-yield bond funds have increasingly attracted investors, compensating them with double-digit returns and beating all domestic fixed-income and equity fund categories.

High-yield bond funds invest primarily in non-investment grade corporate bonds, typically those with credit ratings of BB or lower. Although this universe of 140 funds is grouped together, some carry more risk than others, having different style compositions. While high-yield bonds may not be appropriate for everyone, investors that consider them in asset allocation should pay attention to how the fund is invested, what risks it is taking, and how those risks have been rewarded.

A screen run by Fund Advisor revealed that for high-yield bond funds with at least three years of operating history, the less ‘risky,’ i.e. those that experience less volatility or have a lower standard deviation, tend to perform better than those that assume more risk. Furthermore, on a risk-adjusted return basis, less risky funds also tend to outperform.

To uncover this, we divided high-yield funds with at least three years of operating history into two groups based on the volatility of their returns: those with a standard deviation above the peer group average, and those with a standard deviation below. Surprisingly, the more risky funds lost -0.7% for three years ending April 30, 2003, while the less risky funds returned a positive 4.2% during the same period. Moreover, the average risk-adjusted return (Sharpe ratio) for the first group was -0.3, versus a better +0.1 for the second group. The two groups contained almost the same number of funds. The average three-year annualized return for the entire group was 1.8%, with an average standard deviation of 10.1%.

Standard & Poor’s, through returns based style analysis, studies the style composition of each fund to understand the mix of investment styles that best explains a fund’s behavior. In this case, most of the high-yield funds with high volatility, i.e. the first group, can be considered fairly “pure” high-yield bond funds, since their behavior is mostly explained by the high-yield index used in the regression. The behavior of the less risky funds, in contrast, was best explained by a mix of high yield and investment grade bonds.

Fund Advisor also ran the same screen for the one-, five-, and ten-years periods. The results were the same: less risky funds outpeformed over those periods as well.

High-Yield Bond Funds One YearThree YearsFive YearsTen Years

Avg. Annualized Standard Deviation (%)10.610.19.57.5

Avg. Annualized Return (%)+7.3+1.8+0.5+5.2

Avg. Sharpe Ratio +0.7-0.1-0.4+0.1

Riskier Funds (1st Group)

Avg. Annualized Standard Deviation (%)13.412.111.18.4

Avg. Annualized Return (%)+6.3-0.7-0.9+4.5

Avg. Sharpe Ratio+0.4-0.3-0.5-0.0

Less Risky Funds (2nd Group)

Avg. Annualized Standard Deviation (%)8.38.27.86.2