The Case for a Strategic Allocation to High Yield Bonds

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.

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.

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 7.27% over the 20 years ended August 31, 2023.¹

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.

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.

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.

What should investors expect out of high yield as an asset class over the long term? While past performance is 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, 2023 high yield bonds generated a cumulative total return of 54% compared with 11% for U.S. Treasuries and 29% for investment-grade corporates.³

As Figure 4 demonstrates, there have only been six calendar years with negative returns over the last 26 years and, for investors that had the patience to stay invested, negative return years typically have been immediately followed by outsized return years.

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.

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.