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The Low Volatility Factor In U.S. High Yield Corporate Bonds Does the low volatility effect extend to U.S. high-yield corporates?
BY Hong Xie

EXECUTIVE SUMMARY

• The low volatility effect in equities has been well documented in academia for decades. In the wake of the 2008 financial crisis, low risk investing has received widespread attention from the investment community.

• Our research shows that low risk investing can be applied to fixed income as well. Duration times spread (DTS) is an effective volatility measure of credit risk for corporate bonds. Overlaying the marginal contribution to risk (MCR) approach on the DTS of a corporate bond portfolio and measuring individual bonds’ credit risk in a portfolio context allows for a meaningful way to screen out riskier bonds.

• The S&P U.S. High Yield Low Volatility Corporate Bond Index is designed to measure the performance of U.S. high yield bonds that exhibit low volatility characteristics. The index selects high yield bonds with low MCR rank, which are deemed to have less credit risk and lower return volatility.

• Back-testing shows that the S&P U.S. High Yield Low Volatility Corporate Bond Index had lower return volatility and better risk-adjusted returns than the broad-based, high yield bond universe, along with relatively attractive yields over time.

THE LOW VOLATILITY EFFECT IN VARIOUS ASSET CLASSES

The low volatility effect in equities has been extensively studied and documented by academics and practitioners alike over the past four decades. Black, Jensen, and Scholes (1972) demonstrated that the expected excess return on a security was not linearly related to its beta. The authors found that the alphas of high-beta securities were negative, while the alphas of low-beta securities were positive. Clark, de Silva, and Thorley (2006) constructed minimum-variance portfolios that had annualized realized volatility at three-fourths that of the broad market (11.7% versus 15.4%, respectively). Blitz and Vliet (2007) created decile portfolios based on the rankings of stocks by their three-year realized volatility. Their study showed that the volatility of the top decile portfolio, which contains the low risk stocks, was about two-thirds of the market volatility, while the volatility of the bottom decile portfolio had a standard deviation that was almost twice that of the market.

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