USING HIGH-YIELD BOND AS INPUT TO IMPROVE CORE BOND RISK-REWARD CHARACTERISTICS
This index strategy (QAS S-126) is currently licensed to a U.S. Asset Management Company. For more information, contact www.qas-service.com.
TRADITIONAL “CORE BOND” INVESTMENT APPROACH
The bond market is a very important component of the traditional portfolio construction process. Three main allocation schemes that mix together equity and fixed income instruments became a cornerstone of modern investment management supported with billions of dollars in AUM around the world (such as famous “60/40”):
- Income (up to 100% bond allocation)
- Balanced (40-50% bond allocation)
- Growth (less than 20% bond allocation)
Bonds are generally perceived as a “low-risk / low-return” component, while stocks represent a “high-risk / high-return” part of the portfolio. When a “stock/bond” investment principle is explained to investors, a higher allocation in bonds would require accepting lower returns by definition.
iShares Core US Aggregate Bond ETF (AGG) with roughly $58 Billion AUM represents one of the most popular “core bond” instruments in the US.
AGG has widely diversified exposure in various sleeves of the fixed income universe.
AGG ETF Exposure Breakdowns
As we can see, the traditional core bond (AGG) expected returns are in the range of 2-3%. This is a standard level of return for a low risk investment choice for investors today.
AGG ETF Returns
ADDING HIGH-YIELD BOND TO THE MIX
We, at QAS, believe investors can do better with their core-bond investments.
High-Yield (“Junk”) bonds are not part of the traditional core bond universe due to their high risk profile. High-Yield bonds carry “risk-return” characteristics similar to stocks. We can see that the expected returns of high-yield bonds are much higher (up to 9%). The only problem that remains unsolved is high volatility. Periodically, during major stock market declines, high-yield bonds experience significant drawdowns.
We use iShares iBoxx $ High-Yield Corporate Bond ETF (HYG) as one of the most popular high-yield bond instruments with $14 Billion in AUM.
HYG ETF Returns
Therefore, High-Yield bonds can potentially improve traditionally low expected returns of the core bond investment. However, an effective solution should take into consideration its “high-volatility/large drawdown” factor.
Our target volatility level is around 3%, which is AGG’s (our benchmark in this project) average 20-day volatility.
SYNTHETIC CORE BOND SOLUTION
QAS developed a synthetic “core bond” solution that consists of the High-Yield bond (HYG) and 7-10-yr US Treasury bond (IEF) instruments.
QAS S-126 50/50-30 Index strategy was designed to replace a traditional core-bond investment with a much higher expected return and a relatively low-volatility characteristics solution.
Here are some comparative stats on HYG and IEF ETFs vs. Core-Bond benchmark AGG.
ETFs Comparative Stats
QAS S-126 50/50-30 Strategy has the dynamic 3-regime allocation scheme: Positive, Neutral and Negative. The regimes are changed according to QAS’s own score-based algorithm that compares HYG and IEF’s risk scores against each other.
Regime 2 – Neutral is designed as a hypothetical “50/50” benchmark. The strategy will tilt 30% exposure up and down against the “50/50” benchmark when the QAS algorithm identifies a more favorable risk level and market conditions for either high-yield or treasury instruments.
QAS S-126 50/50-30 Strategy Index’s Regimes
By effectively tilting exposure between “High-Yield” and “7-10-yr treasury” instruments, the strategy captures maximum available gains and at the same time manages to reduce overall portfolio volatility to a minimum. Overall, the synthetic core-bond strategy has a much better risk-return profile vs. the traditional core-bond investment solution that by default assumes low returns.
As you can see from the index performance graph below, the synthetic core-bond strategy (QAS S-126 50/50-30) achieved its objective – significantly improved the traditional core-bond’s return from 3% to 9%, and at the same time managed to maintain portfolio volatility at a very low level (Average 20-Day Volatility is only 3.8%, comparable with 3% volatility of AGG).
QAS S-126 50/50-30 Index vs. HYG, IEF and AGG ETFs (2009-2019)
QAS S-126 50/50-30 Index vs. AGG (2015-2019)