Abstract
By utilizing a modified version of the Black-Litterman model, the authors explore the asset allocation to high-yield bonds based on an investor’s risk profile. In so doing, the researchers use US data on high-yield bonds and over the period 2007–2013. The key finding relates to the strategic asset allocation to high-yield bonds in a simulated global market portfolio depending on an investor’s risk tolerance. In particular, the share of high-yield bonds does not exceed 4.15% of total assets in a global market portfolio over the period 2007–2013, whilst the allocation remains relatively stable and small on a risk-adjusted basis, irrespective of an investor’s risk profile or the phase of the business cycle. In simple terms, the results suggest that high-yield bonds do not seem to merit a favorable treatment in the asset allocation process relative to other financial instruments in a global market portfolio.
Highlights
Even though portfolio diversification is an effective way to minimize risk, correlation patterns of the securities’ returns incorporated in a portfolio can produce unfavorable outcomes.In the aftermath of the global financial crisis, portfolio diversification has transpired to be a strategy with minimal benefits for potential investors, as all major global equity indices were adversely affected
The results suggest that high-yield bonds do not seem to merit a favorable treatment in the asset allocation process relative to other financial instruments in a global market portfolio
We find that that the percentage that should be allocated to high-yield bonds in investment portfolios ranges between 3.72% to 4.15% over expansionary periods, and between 3.78% to 4.07% over contraction periods and depending on the investor’s risk tolerance profile
Summary
Even though portfolio diversification is an effective way to minimize risk, correlation patterns of the securities’ returns incorporated in a portfolio can produce unfavorable outcomes. The lesson that we can learn from the recent global economic shock is of great significance in that portfolio diversification does not necessarily provide the same level of risk when the market is severely compromized. As a matter of fact, in severe economic recessions, the entire diversification process may be an illusion. We use historical return data from a set of indices that track the US equity and bond markets.
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