November 1, 2011
These are major firms in a range of industries and with headquarters in countries including Britain, France, Germany, Spain, Switzerland, Finland, and the Netherlands. These stocks are paying an average of 6.4% and a median of 5.8% in yield. These are impressively high yields, particularly in an environment in which 10-year Treasury bonds are yielding 2.1%. The question, of course, is whether these yields are offset by very high risks.
I used my Monte Carlo portfolio simulator (Quantext Portfolio Planner) to create an ‘efficient frontier’ of yield vs. risk. This is similar to the traditional efficient frontier in portfolio theory, with risk on the horizontal axis. In the yield vs. risk frontier, the vertical axis is yield rather than total return.
In addition to the individual stocks in the table above, I included a set of the traditional fixed income classes: short, medium, and long-term Treasury bonds (represented by the ETFs SHY, IEF, and TLT) and corporate bonds. Investment-grade bonds are represented by LQD and high-yield bonds are represented by HYG. All of these ETFs have options from which we can discern implied volatility.
The Monte Carlo simulation calculated a series of portfolios with the maximum yield for a range of risk levels, using the bond ETFs and the individual stocks. If the stocks are offering an attractive yield relative to their risk levels, they should be close to the ‘frontier’ yields. If the yields do not justify the risks, the yields will be far below the frontier yield at a given risk level.
One of the factors that has some effect on the maximum-yield portfolios is the maximum allowable allocation to any single stock. I have calculated two separate efficient frontiers for portfolios with a maximum allocation of 10% to an individual stock, as well as those where the maximum allocation is 25%. The results are shown below.
Note: the two portfolios in the red circle show the impact of excluding FTE from zthe set of potential investments. The relevance of this test is discussed in a later section
For the individual stocks, I used their implied volatilities and current yields. I also compared their implied volatilities to the Monte Carlo-generated volatilities, and they are consistent.
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