To recognize the benefits of portfolio diversification from high yield bonds, one needs to look at the returns from various ETF portfolios and compare. The table below captures select returns in past the five years and monthly returns since December 2013. We assume that the weight of each asset is the same in the portfolio, that is, the investor has equal exposure to all the ETFs.

Why high yield bonds improve portfolio returns when markets tumbleTo understand the effect of including high yield bonds in a portfolio of ETFs that consists of SPY, XRT and XLY, and DEF, we have considered specifically those periods in the past five years when SPY produced average negative monthly returns. We have also considered the portfolio performance in recent times. From the graph above, it becomes clear that the effect of diversification would have had a positive effect. Average portfolio returns, after including HYG and JNK, would have improved returns. The benefit of diversification is more prominent if the average portfolio returns are compared with returns from portfolio without including bond ETFs. The portfolio returns were also higher than SPY for all the periods in consideration except for December 2013. Although the portfolio returns reduce when the cyclical industry ETFs and SPY go up, for a longer time period, investors were rewarded if their portfolio was diversified with high yield bonds.

Going forward, the effect of bond ETFs would depend largely upon the movement of interest rate and its effect on yield. The asset repurchase strategy of Fed had pushed the yield curve lower to keep the economy growing. Starting 2014, it has begun to slow down repurchase of assets which would increase the rates. If that happens, bond prices would fall making the returns from bond ETFs go lower. However, if other broad economic indicators like economic growth rate, unemployment rate, exports, etc., do not show persisting improvement, the Fed may be forced to pursue liberal monetary policy and keep the interest rate down. In that case, bonds would continue to offer a good diversifying option with returns closely following the rise in the market.

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