Does Taking Higher Risk Lead to More Return In Bonds?

The low volatility anomaly is well-known in equity.  Holding a basket of shares with the highest beta does not generate the highest return.  It has been shown in many different regions and periods.  A similar mechanism may be in action in bonds as well.  The yield is higher when going down the rating spectrum.  But that does not fully compensate the credit quality deterioration beyond a certain point.  Examined 20 years of Bloomberg Barclays bond indices for US and European corporate, buy-and-hold the riskiest credit did not generate a good return.  There seems to be a sweet spot when going down the credit spectrum.

The absolute return (measured as the total return from Jan 1999 to Sep 2019) and risk-adjusted return (measured as Sharpe Ratio taking 1-month LIBOR as the risk free rates for respected currency) for US and pan-European corporate bonds are shown in the following charts.

Historically, BB seems to be the sweet spot.   The extra spread is more than needed to compensate for the increase in credit risk when moving from AAA to BB.   In the end, the default risk is reasonably low even for BB.   BB may also be aided by the long-known fallen angel effect.  Many investment vehicles simply forbid investment in non-investment bonds.  Even when the bond quality is still acceptable after downgraded to BB, those funds have to liquidate the holdings.  This generates artificial fire sales and benefits those who can buy into those downgraded BB.

Deeper into the high yield territory, it is a different story.  When the market is stable and boring, there will be investors chasing for slight more yield without giving much thought about credit issues.   It is nothing like these investors do not know about the extra credit risk coming with the B/ and CC credits – the transition rate from B and CCC to default is as high as 18 and 46% in a 5-year window [S&P 2018 study].  As they fear of missing out, they do not insist to make a return commensurate to the risk before investing. They work on the principle of the musical chair and believe they can get out when times are still good.   

TotalRtnQE
When the credit market is stable.

When the market enters a recession, panic ensues and trading becomes difficult.  Investors with the wrong positions tend to sell at the worst moment and exacerbate the losses.  Even with these fire sales, the default rate would ramp up during the recession and this crystalises disproportionally in B/CCC segment.

TotalRtnRecession
When defaults hit!

The credit analysis and portfolio management skill really show a difference in the riskier end of the credit spectrum.  The variation in performance between high yield funds is thus much larger than between the investment-grade ones.   While I like passive low-cost passive fund structures in general, I see the value in paying for good active funds in the high yield space.