The income contribution from high yield is critical. Historically, the biggest component of bond returns has come from income payouts to bondholders rather than capital appreciation. In fact, over the last 20 years, US high-yield bonds’ annual return due to income has slightly exceeded annual total return. Hence, a strategy that is underexposed to income per unit of risk will likely struggle to generate attractive returns for risk-conscious investors.
Getting the Balance Right
What’s the right mix of assets? That depends on each investor’s needs and comfort level. A simple 50/50 split could be right for an investor with high income requirements and a high risk tolerance, because credit assets are at least twice as volatile as high-quality government debt. So when it comes to risk exposure, an even split between the two asset classes effectively tilts toward credit.
An investor who wants a more balanced exposure would likely incline toward a 65% Treasuries / 35% high-yield allocation, giving up a small amount of return in exchange for lower risk. In practice, investors seeking an optimal mix would also likely allocate to a wide variety of higher-yielding fixed-income sectors, including not only high-yield bonds but also corporate and hard-currency emerging-market debt, inflation-linked bonds and securitized assets.
Most important, we believe keeping the right balance involves an active, dynamic approach that explicitly manages the interplay of rate and credit risks. To that end, credit barbells offer an advantage: combining diversifying assets in a single portfolio makes it easier to manage risk and tilt toward duration or credit according to market conditions.
High-Yield Credit Has Structural Advantages
Although spreads have tightened recently, high-yield credit is still attractive, in our view. And it has several structural advantages over investment-grade credit too, beyond its bigger exposure to credit risk.
The high-yield market is relatively small and has tended to benefit as bond issues are promoted to and demoted from investment grade. Rising stars have typically outperformed by approximately 60 basis points in the months before they leave the high-yield index, as the market anticipates their promotion. And once rising stars enter the investment-grade market, high-yield-focused investors have tended to sell and redeploy the proceeds across similar high-yield credits, boosting their price.
Fallen angels also enjoy supportive conditions. Fallen angels tend to be large relative to the average high-yield name and to trade with tighter spreads than the broader index. Investors who benchmark to the high-yield index often need to buy these new and sizeable index constituents to remain aligned with their benchmark.
At the same time, fewer of the investment-grade investors that held these bonds before they fell below investment grade are forced sellers than in the past, when guidelines compelled them to sell upon downgrade; many of these investors now have the flexibility to wait for a recovery in the issuers’ rating.
The high-yield market’s small size has other advantages. Downgraded high-yield bonds can attract strong support from investors that specialize in distressed names, owing to limited supply.
Whereas investment-grade corporate bonds are generally not callable, high-yield issuers can call their bonds—and sometimes do so above the call price stated in the prospectus, generating windfall profits for bondholders. That’s a potentially valuable feature when, as today, bonds are trading at a discount.
Stay High Quality to Mitigate Risk
To reduce some credit risk, an investor might cut out low-quality, CCC-rated bonds, the riskiest slice of the high-yield universe. These securities are at the highest risk of default (Display), and steering clear might make sense during the late stages of a credit cycle when economic conditions are tough for corporates. This approach would concede a small amount of return in exchange for significantly lower default risk.
