12-Feb-24 DWS Research Institute

High Yield Bonds for Allocators

Evaluating the use of high yield within an investment portfolio

  • Investing strategically into high yield corporate bonds can help to supplement yield or income objectives or help to diversify away from traditional equity and fixed income risks.
  • Across the high yield investment universe, investors can express views across spread, credit rating, duration, and industry, allowing access to differing levels of risk and yield that may be more or less suitable for different market environments.
  • Historically, the higher quality segment of this market has realized better risk-adjusted returns, where lower quality names have provided more return upside in risk-on markets.
  • While distressed market environments can introduce significant price volatility, subsequent returns following periods of spread widening have, on average, fared well for higher yield investments.
  • In significant selloffs, credit spreads typically widen prior to ratings downgrade and rally following the downgrade. The average issuer experienced nearly 550bps of spread widening three months prior to downgrade and nearly 450bps of spread tightening in the three months following downgrade.

Historically, investors have looked to fixed income markets to access higher quality, fixed rate returns to either supplement yield or income objectives or to help diversify away from traditional equity investments that often dominate portfolios. The growth and expansion of credit markets in recent decades has resulted in the tremendous growth of speculative-grade credit, now more commonly known as high yield. Once considered to be a more exotic, non-core fixed income asset class, high yield has now grown to serve an important strategic and tactical purpose within most investor portfolios across the risk spectrum.

This paper seeks to provide the reader with a broad overview of the high yield market, highlighting the strategic and tactical cases for high yield investing as well as addressing questions such around liquidity and market technicals, characteristics of different segments of the high yield market, and how to think about the component risks of high yield bonds. The main areas of focus of this paper can be summarized into four main categories:

  1. Strategic Allocations: What is the strategic risk and return case for high yield within a portfolio, and what is a reasonable credit risk premium to be demanded by high yield investors?
  2. Characteristics: What are the underlying characteristics of the high yield market, broken down by industry and by quality? How might shifting allocations based on industry or credit rating impact risk and return characteristics?
  3. Market Timing: On a more tactical basis, when has it historically made more sense to be opportunistically overweight high yield as an asset class?
  4. Component Risks: Between the credit spread and risk-free treasury yield, how have these component risks interacted or contributed to the total risk of the asset class?

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