High-yield bonds: Equity-like returns with lower risk

Doug Peebles head of fixed income at AllianceBernstein looks at the way portfolio construction may need to be adjusted to reflect the behaviour of high-yield debt.

On the surface, high-yield bonds look a lot like their relatives in the fixed income world. But in some key respects, high-yield debt acts a lot more like equities than like other bonds. This has some often unappreciated implications for portfolio construction.

Instead of thinking about how much of their bond exposure they should allocate to high yield, we think investors should ask how much equity exposure they should allocate to high yield. Recent research by my colleagues Gershon Distenfeld, Ashish Shah and Jonathan Nye provides a number of reasons.

First, the performance of high-yield bonds traditionally has not followed other fixed-income sectors very closely. Looking back over three decades, the correlation of high-yield bonds with investment-grade bonds has been just 0.30. With US stocks, the correlation has been 0.56. Clearly, high-yield bonds (as represented by the Barclays Capital US Corporate High-Yield 2% Issuer Capped Bond Index) have historically tracked stocks much more closely than they’ve tracked investment-grade bonds (represented by the Barclays Capital US Aggregate Index).

Why is this? Well, the returns of high-yield corporate bonds, like equities, are strongly linked to the business results and fundamentals of the companies they represent. While this is also true for investment-grade corporate bonds to a limited extent, high-yield bonds offer a greater incremental yield over government debt than investment-grade corporates because they typically are more leveraged or have less-certain cash flows, which makes them more vulnerable to weakening business conditions or, say, a new competitive threat.

On the other hand, rising interest rates are a less significant problem for high-yield bonds than for investment-grade corporates. In fact, high-yield bonds tend to outperform investment-grade bonds when interest rates rise, because interest rates usually rise when business conditions are strong.

For these reasons, high yield, unlike other fixed income sectors, is typically insensitive to movements in interest rates. In fact, US high-yield bonds have a correlation of just 0.04 with 5-year US Treasuries over the long term.

Jonathan Boyd
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