Investigating the relationship between high‐yield bonds and equities and its implications for strategic asset allocation during the Great Recession

• Author: Georgios Menounos,Sofoklis Vogiazas,Constantinos Alexiou
• Date: 01 July 2019
• Published date: 01 July 2019
• DOI: http://doi.org/10.1002/ijfe.1711

RESEARCH ARTICLE

Investigating the relationship between high‐yield bonds and

equities and its implications for strategic asset allocation

during the Great Recession

Georgios Menounos

1

| Constantinos Alexiou

2

| Sofoklis Vogiazas

3

1

RBU, Structured Solutions, Piraeus Bank,

Athens, Greece

2

School of Management, Cranfield

University, Bedford, UK

3

Operations Division, Black Sea Trade

and Development Bank, Thessaloniki,

Greece

Correspondence

Sofoklis Vogiazas, Black Sea Trade and

Development Bank, Thessaloniki, Greece.

Email: svogiazas@bstdb.org

JEL Classification: C10C61G11

Abstract

In this paper, we focus on investing in U.S. high‐yield bonds during the period

2007–2013, a period that covers the Great Recession in the aftermath of the

global financial crisis of 2007–2008. First, we use the Fama and French

three‐factor model to delve into the relationship between the risk‐adjusted

returns of high‐yield bonds and equity market risk factors. Second, we gauge

the extent to which the risk‐adjusted returns of high‐yield bonds are signifi-

cantly higher than equity and investment‐grade bonds' risk‐adjusted returns.

Third, by using a modified version of the Black–Litterman model, we explore

the asset allocation to high‐yield bonds, accounting for investors' risk tolerance.

Our findings suggest that equity market risk factors have significant explana-

tory power for high‐yield bonds' risk‐adjusted returns, whereas the hypothesis

of superior returns on high‐yield bonds over investment‐grade corporate bonds

and equities cannot be supported. Our key contribution relates to the strategic

asset allocation to high‐yield bonds. Our results suggest that the share of

high‐yield bonds does not exceed 4.1% of total assets in a global market portfo-

lio over the period 2007–2013. Notably, the share of high‐yield bonds in a

simulated portfolio remains relatively small and stable on a risk‐adjusted basis,

irrespective of an investor's risk profile or the phase of the business cycle.

KEYWORDS

asset allocation, Black–Litterman model,Fama–French three‐factor model, global financial crisis,

high‐yield bonds

1|INTRODUCTION

A major way that portfolios can effectively reduce risk is

by combining investments whose returns do not move in

tandem. Sometimes, a subset of assets will go up in

value, whereas another will go down. The fact that these

may offset each other creates the diversification benefit

that is attributed to portfolios. However, an important

issue is the sensitivity to correlation risk, whereby the

securities' returns in the portfolio can change in an

unfavourable manner, especially during times of market

stress.

During the global financial crisis (GFC), the diversifi-

cation benefits were relatively small. Evidently, all major

global equity indices declined in unison. The lesson is

that, although portfolio diversification generally does

reduce risk, it does not necessarily provide the same level

of risk reduction during times of severe market turmoil as

it does when the economy and markets are operating

smoothly. In fact, if either the economy or markets

Received: 17 August 2017 Revised: 2 August 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1711

Int J Fin Econ. 2019;24:1193–1209. © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 1193

collapse, then any diversification benefits could simply

be illusory.

Herein, data on past returns from indices tracking the

U.S. equity and bond markets are used. We explore the

risk‐adjusted returns of high‐yield bonds in relation to

equities, as well as the risk‐adjusted returns of high‐yield

bonds relative to investment‐grade bonds. The contribu-

tion of the paper is twofold: First, to the best of our

knowledge, this is the first study to explore the relation-

ship between high‐yield‐bond risk‐adjusted returns over

the period of the GFC (December 2007–June 2009) using

the Fama and French three‐factor model (Fama &

French, 1993). In this context, we investigate whether

the risk‐adjusted returns of high‐yield bonds can be

explained effectively using equity market risk factors.

Second, we use Black and Litterman's (1992) model for

all major asset classes represented by 25 benchmark indi-

ces that represent an equal number of sub‐asset classes,

simulating the global market portfolio over 2007–2013, a

period that includes both phases of the business cycle.

Thereby, we analyse what proportion of their portfolios

investors of different risk tolerances should dedicate to

high‐yield bonds.

The rest of the paper is organized as follows: Section 2

provides an overview of related literature, whereas

Section 3 elaborates on the data and methodological

framework adopted in the empirical investigation.

Section 4 discusses the results of our analysis, whereas

Section 5 provides some concluding remarks.

2|LITERATURE REVIEW

High‐yield bonds are deemed to lie somewhere between

investment‐grade corporate debt and equity securities.

High‐yield bond prices are volatile and, compared with

those of investment‐grade bonds, tend to be less affected

by interest rates, instead exhibiting a relationship with

equity market changes. The stock‐to‐bond return rela-

tionship has certainly received much research attention.

Shiller and Beltratti (1992) find changes in stock prices

to be highly correlated with long‐term bond yields,

whereas Campbell and Ammer (1993) demonstrate a

weak correlation. More recently, a strong time depen-

dency in the stock–bond correlation has been claimed

(Cappiello, Engle, & Sheppard, 2006; Gulko, 2002; Jones

& Wilson, 2004). IMF (2015) states that, in 2008–2009,

following the recent crisis, global asset market correlation

jumped to around 80%. Before this (1997–2007), such

correlation lay at around 45%, close to what it had been

historically. A crash has in the past always been accom-

panied by high correlations, due to the markets being

most strongly influenced by panic. However, following

this recent crisis, despite heavily increasing asset prices,

correlations stayed at a level well above what had been

seen prior to the crisis, at about 70%, which suggests a

high degree of interconnection within the global asset

management industry. This left investors few options for

portfolio diversification.

2.1 |The presence of an equity element in

high‐yield bonds and the business cycle

Contemporary work on corporate debt is heavily based

on Black and Scholes (1973) and Merton (1974). Accord-

ing to Merton, one can think of risky corporate bond

holders as riskless bond holders who have issued put

options on the equity of the firm in question. With an

increase in volatility, we see an increase in the value of

the put options, such that equity holders benefit at the

expense of bond holders. As Bookstaber and Jacob

(1986) find, when long‐term corporate bonds decline in

quality, there is an increase in their returns' correlation

with those on common stock. Blume and Keim (1987)

make a similar observation on the risk–return character-

istics of junk bonds. Ramaswami (1991) shows that

noninvestment‐grade bonds' return variance is more

heavily affected than that of investment‐grade bonds by

sector‐industry and firm‐specific factors. Also, Regan

(1990), who includes phases of the business cycle in his

study, suggests that junk bond and low‐quality stock

performance tends to depend on the riskiness of the indi-

vidual companies in question rather than swings in the

capital markets.

Cornell and Green (1991) find that junk bond returns

are less sensitive to movements in long‐term interest rates

and become more sensitive to equity risk than invest-

ment‐grade bond returns are, whereas they also suggest

that high‐yield bond returns are more influenced by

fluctuations in interest rates, and less by changes in stock

prices, in contraction periods as compared with expan-

sion periods. Similar results are reported by Kihn

(1994), whereas Zivney, Bertin, and Torabzadeh (1993)

hint that Cornell and Green overstated the actual sensi-

tivity of investment‐grade bond returns to equity market

risk factors. The results of Shane (1994) and Reilly and

Wright (2002) suggest that junk bond returns are more

sensitive to equity risk and less sensitive to movements

in interest rates during phases of weak economic activity,

whereas Patel, Evans, and Burnett (1998) find that high‐

yield bond returns are significantly influenced by changes

in stock prices over such phases. Along the same lines,

Domian and Reichenstein (2008) find that high‐yield

bonds embed investment‐grade bond, stock, and even

cash characteristics, whereas the equity constituent of

their returns exhibits a small‐cap equity tilt. Using panel

1194 MENOUNOS ET AL.