Evidence and implications of the predictability of high yield bond returns

Abstract

This study demonstrates that roughly one quarter to one-third of the monthly returns of the Merrill Lynch High Yield Bond Indexes from September 1988 through June 2009 can be explained by predetermined variables. The study also shows that out of sample forecasts of Sharpe ratios from GARCH models are able to predict favorable and unfavorable times to invest in high yield bonds and would have allowed investors to avoid most of the months in which high yield bonds suffered substantial losses. These out of sample results are robust when applied to Vanguard and Fidelity high yield bond mutual funds. Overall, the results support the case for allocating funds to high yield bonds only when favorable risk-return tradeoffs are forecast, particularly in light of the modest risk adjusted high yield bond returns from passive strategies over the sample period and the recent introduction of high yield bond exchange traded funds that have substantially reduced transactions costs. © 2012 Macmillan Publishers Ltd.