Fighting “Fool’s Yield”: A Quantitative Solution to the Pitfalls of Passive High Yield Investing

open_access
Open Access
Author:
Kelly, Pearse
Area of Honors:
Finance
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
Jason Lunn, Thesis Supervisor
Brian Spangler Davis, Thesis Honors Advisor
Keywords:
Factor investing
Corporate Bonds
High Yield
Distressed
Abstract:
The purpose of this paper is to track the raw and risk-adjusted performance of a two-factor high yield corporate bond portfolio relative to its respective benchmarks and examine the return characteristics of distressed and high yield bonds. At the index level, CCC-rated and B-rated bonds underperform higher-rated bonds on both a raw and risk-adjusted basis. The high number of defaults in these two indexes offsets the higher yield. Essentially, the higher yield does not translate into higher returns. This is known as “fool’s yield.” However, this paper finds that passive investing in lower credit quality bonds can exhibit higher risk-adjusted and raw returns relative to BB and higher credit ratings by quantitatively tailoring the portfolio through two factors: price and time to maturity. A high yield bond portfolio that holds low-priced bonds exhibits a positive skewness of returns that offsets the losses from defaults, and the longer time to maturity lowers the number of defaults by creating for a longer runway for management to turn things around.