Home > Library > Stable Times > Volume 11, Issue 1  

Strategic Allocations to High Yield Corporate Debt in Stable Value Funds

Portfolio managers typically strive to maximize risk-adjusted returns. For a portfolio that is being used to fund a specific liability (e.g., a college tuition payment in five years), risk is typically measured relative to the liability. For portfolios without clearly defined liabilities, maximizing risk-adjusted total returns would typically be the objective. A client’s risk tolerance can be directly incorporated by adjusting the risk penalty scaling factor used in the analysis.¹

Portfolio Theory 101 states that combining investments (even assets that look risky in isolation) whose returns have low correlations reduces the overall risk level. While we often think that fixed income benchmarks like the Intermediate Government Credit Index are highly diversified (and it is if you are thinking about the number of different issuers or securities), it turns out that a single risk factor (five-year Treasury rates) can explain over 95 percent of its return variability (see Exhibit 1). Therefore, if our goal is to maximize risk-adjusted total returns, adding a prudent amount of high-yield corporate and emerging-market debt (even on a purely passive basis) can increase the portfolio’s expected returns without increasing total volatility. In addition, diversifying the portfolio with some hedged non-U.S. dollar bonds, while not increasing expected returns (if done passively), will actually reduce the total volatility of the portfolio. Therefore, investors with all risk preferences should applaud such a change. This happens because these sectors exhibit much lower correlations to Treasury rate changes.

While AllianceBernstein has included all of these sectors in our fixed income portfolios (including our stable value portfolios) for at least a decade, the balance of this article will specifically focus on the case for high-yield corporate debt. We will first examine the risk and return implications from a market-value perspective before closing with an examination of any nuances created by the presence of book-value wrappers. We will update and expand upon the analysis we presented on this topic at the spring 2005 stable value conference.

Market-Value Analysis
Over the last 23 years, high-yield corporate debt has returned just under 10 percent annualized and has outperfomed five-year Treasury bonds by over 200 basis points per year. While the long run performance has been stellar, focusing on this average outperformance would obscure the highly volatile nature of these returns. The standard deviation of the calendar-year returns is over 12 percent (see Exhibit 2). It is the fear of this volatility that has caused many investors to forgo the strong excess returns that this sector has historically generated.

When looked at in isolation, high-yield corporate debt is certainly risky. However, unlike the Intermediate Government Credit Index, the returns of the High Yield index display a very low correlation (<20 percent) to Treasury rates changes (see Exhibit 3). This extremely low correlation with the dominant risk factor affecting traditional fixed income benchmarks means that the addition of a modest amount of high-yield corporate debt will not materially increase total portfolio risk.

For this analysis (see Exhibit 4), we compare the historical returns of the Lehman Intermediate Government Credit Index to a strategy that overlays a set percentage of the Lehman High Yield Index hedged with five-year Treasuries. At a 5 percent overlay level, the portfolio outperforms the Intermediate Government Credit Index by 13 basis points per year (consistent with the 200-basis-point-plus outperformance of the sector). The standard deviation of calendar-year returns actually is slightly lower for the 5 percent overlay strategy than the straight index (5.09 percent vs. 5.17 percent). Furthermore, because high yield has historically outperformed during periods of rising interest rates, the overlay strategy outperforms the straight index in every calendar-year period when the Intermediate Government Credit Index generated relatively low (or negative) returns.

The impact on average credit quality is also small. With 5 percent allocated to high yield, the average credit quality of the portfolio can still be comfortably maintained in the AA category (if desired). Finally, while high-yield securities are typically less liquid than the other investment grade components of the bond market, given the modest allocations that we are talking about, only fund level cash flows greater than 10 percent would force a need to rebalance the position.

The overlay percentage can be increased to 15 percent before the risk matches the Intermediate Government Credit Index. At this level, the overlay strategy outperformed by 37 basis points. Please keep in mind that this performance advantage occurs even if we assume that the allocations are purely passive (i.e., the portfolio manager does not add value through adjusting the sector weight through time or via security selection). Manager skill can amplify the results.

The conclusions of this historical risk analysis are also corroborated by ex-ante risk analysis performed using the Lehman Point risk model as well as AllianceBernstein’s Wealth Forecasting System. Therefore, at modest allocation levels, the addition of a diversified high-yield corporate debt position to a traditional core fixed income portfolio should be unambiguously favored by investors who want to maximize risk-adjusted total returns, regardless of risk tolerance levels.

Before moving on to address issues pertaining specifically to stable value portfolios, we would like to briefly comment on the relative risk implications of such an overlay strategy. The amount of the relative risk being generated from a 5 percent overlay (about 12 basis points per month, according to Lehman Point) is less than the risk generated from a +/- .5 year duration bet (14 basis points per month) that almost all clients/managers are comfortable with. Furthermore, the probability of winning with a passive high-yield overlay strategy each month is almost 60 percent (70 percent for calendar-year periods). Most portfolio managers could not make the same statement about their duration betting strategies.

Implications for Stable Value Portfolios
The stable value investment option is often the recipient of large allocations from risk-averse investors. Therefore, some clients or managers believe the inclusion of any “risky” high-yield securities would be inappropriate. However, the decision to include one or more securities in a portfolio is made by considering their impact on the entire fixed income portfolio and, even more broadly, the investor’s overall asset allocation. Are 10-year Treasury bonds too “risky?” They have similar price volatility as the high-yield index (30-year Treasuries are a lot more volatile than the high-yield index). We have never seen a mandate that precludes 10-year Treasuries from a stable value portfolio, but prudent guidelines would undoubtedly prevent a portfolio that was invested only in these long-duration securities. The same tenet holds for the inclusion of high-yield securities.

In many ways, it should be much easier to hold a modest high-yield allocation in a stable value portfolio versus an unwrapped fixed income allocation. The period-to-period volatility is actually less of an issue for stable value funds because of wrapper smoothing. Wrappers allow stable value participants to focus on the correct long-run decision without being caught up in the short-run volatility. This is what allows an individual participant who would otherwise give up the 150 basis points excess returns that intermediate bonds typically earn over money market funds in order to get the day-to-day stability on money that typically won’t be used for years.

If high-yield corporate debt generates excess returns over the long run, the crediting rate that stable value participants earn will be higher if a portfolio invests in these securities. If this investment is maintained at an appropriate level, there will be no noticeable impact on crediting rate volatility (see Exhibit 5).

On an opportunistic basis, adding high yield to a stable value fund is going to be less risky than lengthening a portfolio’s duration. If the manager lengthens duration, rising interest rates would hurt in two ways. The manager’s poor relative returns will detract from the fund’s return at the same time that the stable value returns will already be lagging changes in interest rate levels. High-yield underperformance has typically occurred during periods of falling interest rates. Therefore, any performance impact will be muted by the fact that crediting rates naturally outperform falling interest rates. Another diversification benefit may exist with respect to stable value fund cash flow impacts. High-yield performance is positively correlated with stock performance. Therefore, underperformance in the high-yield allocation is likely to occur when stocks are falling. Typically, money has moved into stable value funds when stock price fall. This would help dilute the impact on crediting rates from the underperformance of high-yield bonds.

Again, the analysis shown above assumes no manager skill at the sector or security level. Obviously, any such skill would improve the results further. While we believe that we have presented a very convincing argument for the inclusion of a modest allocation to this sector for stable value portfolios over the long run, we would close by noting that spreads are currently very tight. We believe, in the short run, that expected excess returns will be well below historical levels. As such, we have reduced our high-yield holdings below the levels we expect to hold in the long run and have been substituting bank loans over traditional high-yield securities.

Read Next: The Relative Value of GICs: "Show Me the Spread"