High-yield versus investment-grade bonds: less risk and greater returns?

Abstract

Using Bank of America/Merrill Lynch bond yield indexes, we compare the returns on investment-grade bonds to the returns on high-yield bonds over the period from January 1997 through mid-August 2011, a period marked by the collapse of the technology sector in early 2000 and the financial crisis in 2008. We compare return and risk measures under the assumption of a normal distribution with those obtained under the assumption of a stable distribution. When a normal distribution is assumed, we see a higher expected return associated with a lower SD on the high-yield bond returns relative to investment-grade bond returns. However, we also find that the returns on both high-yield bonds and investment-grade bonds exhibit stable (fat-tailed) distributions, with the fat tail more pronounced for the high-yield bond series. These results suggest that the assumption of a distribution that allows for fat tails and skewness is important for identifying the risk and return characteristics of these bond series.

Keywords:

• high-yield bond returns
• investment-grade bond returns
• stable distribution

JEL Classification:

• G12
• G10

Acknowledgement

The authors are grateful to John Nolan for permission to use the software STABLE for Windows in their research. www.RobustAnalysis.com.