A great portfolio requires a number of things, but arguably one of the most crucial is balance. While U.S. stocks and investment grade bonds are generally cornerstones of this balancing act, for many it is unclear how high yield bonds fit into this equation.
Though the income producing potential of high yield is largely recognized, many shun the asset class due to its volatility reputation or concerns about downside. But are these perceptions accurate and is avoidance of high yield a mistake?
We believe high yield is not only misunderstood, but it can be a crucial portfolio component. This arguably becomes clear when taking a closer look at two vital metrics: downside capture and risk-adjusted returns.
Why high yield?
While one might expect high-yield bonds to have significant volatility and downside, that has not been the case over the trailing decade. High yield has seen just 20% of the downside of U.S. equities, while international securities were even more sluggish. It is true that traditional higher-quality bonds saw better levels of downside capture, but this came at a meaningful reduction in total returns.
In fact, high-yield bonds posted more than two and a half times the returns of traditional bonds over this period. What’s more, high-yield bonds provided 88% of the returns of U.S. equities with less than half the volatility over the same period1. As returns and volatility viewed separately tell only half a story, investors need to consider risk-adjusted returns when making investment decisions. This is where high-yield shines.
(source: Morningstar as of 12/31/18, time period: 1/1/09 to 12/31/18. Past performance does not guarantee future results) U.S. equities: S&P 500 – a broad market index representing large cap American companies. Investment Grade bonds: Barclays US Aggregate 7-10 Index –tracks the performance of the broad U.S. investment-grade, fixed-rate bond market with 7-10 years until maturity. International equities: MSCI EAFE Index – tracks large caps in developed markets ex-North America.
From a risk-adjusted return perspective, high yield topped not only equities, but investment grade bonds as well. Notably, the results weren’t even that close either, as high yield easily beat out its more “traditional” counterparts by a relatively wide margin.
We acknowledge that high-yield isn’t an asset class that fits neatly into either an equity or traditional fixed-income bucket. However, this could put high yield in a sweet spot between equities and more traditional fixed income, making the category an interesting bridge for some portfolios.
This may be especially true when considering the kinds of characteristics that high yield can potentially bring to a portfolio. Not only has high yield produced downside capture better than what many might expect, but it is also a leader in terms of historical risk-adjusted returns. With metrics such as those, high yield may be just the piece that is missing from a balanced portfolio in today’s investing climate.
1Source: Morningstar as of 12/31/18