Why junk bonds aren't a good portfolio fit

(MoneyWatch) On May 24, Vanguard announced that it was closing its high-yield corporate fund (VWEHX) to new investors. The reasoning behind the closure was strong cash flows into the fund. Vanguard CEO Bill McNabb said the following:

"In this prolonged low-rate environment, we continue to see investors turn to high-yielding alternatives - including money market holders moving to bond funds, U.S. Treasury bond holders moving to high-yield corporate funds, and bond fund holders moving to dividend-paying stock funds. And we've cautioned investors accordingly about reaching for yield. The flows into the High-Yield Corporate Fund have been particularly acute, so we're taking these proactive steps to preserve the ability of the advisor to manage the fund effectively and protect the interests of existing shareholders."

Today, I will look at whether it makes sense to add high-yield bonds to a portfolio. From inception (Dec. 27, 1978) through 2011, VWEHX returned 8.8 percent per year. The following are the annualized returns of two alternative fixed income indexes over the same period:

• Long-Term Government Bonds -- 9.6 9.9 percent
• Barclays Capital Credit Bond Index Intermediate -- 8.4 8.6 percent

While the Vanguard fund carried much higher yields than either of these two indexes, the fund's realized returns were comparable to the returns of the Barclays index (which has less credit risk) and the returns of an index with no credit risk.

However, as we have discussed, looking at asset classes or investments in isolation isn't sufficient. Investors should look at how their addition impacts the risk and return of the entire portfolio. Looking at things in the whole is the only right way to view things. Using Morningstar's database, which goes back 20 years, we can do just that.

During this period (March May 1992-April 2012), VWEHX returned 7.4 percent with a standard deviation of 8.3 percent, and five-year Treasuries returned 6.3 percent with a standard deviation of just 4.5 percent.

We will now compare two portfolios, each with an allocation of 60 percent to the S&P 500 Index. Portfolio A will allocate its 40 percent fixed income allocation to VWEHX, while Portfolio B invests in five-year Treasuries. Portfolios are rebalanced annually.

• Portfolio A returned 8.3 percent per year with a standard deviation of 14.0 percent.
• Portfolio B returned 8.3 percent with a standard deviation of just 10.8 percent.

Thus, while VWEHX produced higher returns during this period, its addition to the portfolio not only didn't result in higher portfolio returns, but it resulted in a portfolio with greater volatility.

Portfolio B was a much more efficient one. Note that the quarterly correlation of VWEHX to the S&P 500 was 0.67, while the correlation of the five-year Treasury to the S&P 500 was -0.26, making the five-year Treasury a more effective diversifier of the risks of stocks.

To summarize, investors in VWEHX haven't been rewarded with greater portfolio returns, let alone greater risk-adjusted portfolio returns.

Image courtesy of Flickr user 401(K) 2012.