October 2022 / INVESTMENT INSIGHTS
The 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.
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.
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