October 2022 / U.S. FIXED INCOME
Case for a Strategic Allocation to High Yield Bonds
Hybrid characteristics provide attractive risk/reward profile.
- High yield bonds, in our view, have a key role as a strategic long‑term investment and a mainstay allocation in a well-diversified portfolio.
- High yield bonds have an attractive risk/reward profile, having historically provided equity‑like returns with less volatility than stocks.
- Investors have been able to recognize much of high yield’s value by maintaining a long‑term allocation and taking advantage of the regular coupon payments.
High yield (HY) bonds, in our view, have a key role as a strategic long‑term investment and a mainstay allocation in a well‑diversified portfolio. Historically, high yield bonds have provided equity‑like returns with less volatility. Investors have been able to recognize much of high yield’s value over time by maintaining a long‑term allocation and taking advantage of the potential compounding effect of regular coupon payments.
Yields and Spreads Over Time
(Fig.1) Wider spreads to Treasuries indicate greater risk
The High Yield Risk/Reward Dynamic
High yield bonds are typically issued by companies that are rated below investment grade by one or more of the three main credit rating agencies. Due to their lower credit ratings, investors typically receive higher yields on below investment‑grade bonds in exchange for greater risk of default. This risk/reward dynamic is also expressed through credit spreads on high yield bonds, or their incremental yields over similar‑maturity U.S. Treasuries, which are perceived to carry near‑zero default risk. Typically, wider spreads indicate greater perceived risk.
Hybrid Asset Class
High yield bonds are often considered to be a hybrid asset class because they tend to exhibit characteristics of both fixed income and equities. Like most other fixed income securities, high yield bonds offer a steady stream of income in the form of coupon payments, which averaged 7.40% over the 20 years ended August 31, 2022.1
However, high yield bonds tend to be more equity‑like in how they behave, given that credit (default) risk is the primary risk associated with investing in the asset class. Thus, unlike most other traditional fixed income instruments whose performance is closely tied to changes in interest rates, high yield bonds’ performance tends to be much more strongly linked to the business results and fundamentals of the companies that issue them.
Positioning in a Diversified Portfolio
Given their hybrid nature, high yield bonds have a unique and attractive risk/reward profile, having historically provided equity‑like returns with less volatility than stocks. Therefore, they can be thought of as either part of an overall fixed income allocation or a potential equity replacement. For fixed income investors, high yield bonds provide the potential for higher yields and greater returns, while also adding important diversification from traditional fixed income investments.2 For equity investors, particularly those that may be more risk averse, high yield bonds can offer similar returns with lower volatility and potential downside than stocks.
Income as a Key Source of Return
Most high yield bond portfolio managers focus on opportunities for both income and price appreciation as they invest. However, an analysis of historical sources of return shows that, unlike stocks, high yield bonds have typically derived the majority of their long‑term total returns from income rather than capital appreciation.
Characteristics of a Hybrid Asset Class
Their relatively high and generally consistent coupon payments are a key reason why high yield bonds have historically exhibited lower volatility than stocks. Because their long‑term returns have tended to be so heavily income driven, it pays to think of high yield bonds as a long‑term strategic investment because the compounding effect of these regular coupon payments can be meaningful over time.
Key Asset Class Metrics
(Fig.2) Twenty years ended August 31, 2022
Historical Performance and Relative Returns
What should investors expect out of high yield as an asset class over the long term? While past performance is not indicative of future returns, history can serve as a helpful reference point. Over the long term, high yield bonds have outperformed almost every other major fixed income asset class. In fact, in the 10 years ended August 31, high yield bonds generated a cumulative total return of 74%, compared with 19% for U.S. Treasuries and 43% for investment‑grade corporates.3
Long‑Term Sources of Return
(Fig.3) Compounding of coupon payments can be meaningful.
As Figure 4 demonstrates, there have only been five calendar years with negative returns over the last 25 years and, for investors that had the patience to stay invested, negative return years typically have been immediately followed by outsized return years.
High Yield Calendar Year Returns
(Fig.4) Historical calendar year returns, U.S. high yield*
Performance Through Market Cycles
For high yield bonds, credit cycles tend to drive performance more than any other single factor, so a proper understanding of the stages of the economic cycle—and their investment implications—is critical. Below we highlight the key components of a typical market cycle and discuss how we would typically expect high yield bonds to perform in each phase.
Recession: High yield bonds tend to be susceptible to recessionary environments as economic downturns typically result in lower economic activity and make it more difficult for high yield issuers to service their debt. Credit spreads also tend to widen in such environments in anticipation of increasing defaults. In recessionary environments, high yield bonds tend to fare better than stocks but generally underperform “safer” fixed income asset classes such as Treasuries as investors flock to safety.
Components of the Credit Cycle
Repair: During the repair phase of the economic cycle, businesses generally seek to improve their balance sheets by trimming unproductive assets and paying off or restructuring debt. Default risk during these periods tends to decline as economic activity increases and it becomes easier for companies to service their debt. High yield bonds tend to outperform in these environments as default rates fall, credit spreads narrow, and higher coupons contribute to returns in excess of Treasuries.
Economic Expansion: During economic expansions, economic and credit conditions typically improve. Companies are generally able to earn more profits, making it easier for them to service their debt. Spreads tend to narrow. High yield bonds tend to outperform. When the cycle matures, interest rates rise as the Federal Reserve tightens monetary policy to slow the economy. High yield bonds tend to be more resilient to rising interest rates than other fixed income asset classes due to their shorter duration4 and higher coupons.
Understanding Key Risks
Given the risk/reward trade‑off associated with any investment, it’s important to acknowledge and understand not only opportunities, but also key risks. High yield bonds have an asymmetrical nature of risk in that price appreciation potential is often limited by the fact that they typically pay back par at maturity (or sooner, if called by the issuer). Meanwhile, defaults can trigger significant principal losses and wipe out coupon gains, resulting in an outsized impact to the downside.
Therefore, when investing in high yield, it is important to work with an experienced portfolio manager with expertise in bottom‑up credit research and a strong long‑term security selection track record. Acknowledging that defaults are an inherent part of the asset class, the goal of most high yield managers isn’t necessarily to avoid default risk altogether; rather, the goal is to understand and measure key sources of risk and then seek an adequate level of compensation via a return (or spread) over the risk‑free rate to compensate for that risk. Backed by this risk management, we believe investors can maintain a long‑term allocation to the high yield bond asset class in aiming to take advantage of its attractive income over time.
High Yield Spreads vs. Defaults
(Fig.5) Defaults are an inherent part of the asset class.
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