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.
Second, high-yield assets have delivered annualized returns only marginally below those of equities, with almost half as much volatility, over the past three decades. Yet high-yield bonds are less risky than equities, in that bondholders get paid before shareholders in bankruptcies.
Since high-yield’s correlation to equities is low, an allocation to high-yield bonds can significantly improve the risk and return characteristics of an equity portfolio (Display). Their low correlation to other types of bonds means that an allocation to high yield can significantly improve the efficiency of a diversified stock/bond portfolio, as well.
All of this raises the question: why do investors continue to think of high yield as a (higher risk) part of their bond allocations? Instead of pigeonholing high-yield bonds because they “look like bonds,” our research suggests that investors should consider high-yield bonds as a worthy replacement for part of a portfolio’s equity exposure-or even as a standalone allocation distinct from both stocks and bonds.
Of course, there are caveats. Transaction costs can be significantly higher for high yield than for equities, because of high yield’s lower liquidity. Interest rates at historic lows also make bonds of all kinds less attractive than usual. Indeed, the extraordinarily low interest-rate environment that we’re in today is virtually uncharted territory. It’s possible that a rapid increase in rates, perhaps due to renewed inflation fears, could make high-yield debt more sensitive to rising interest rates than it has been in the past.
Nonetheless, we think that high yield can provide valuable diversification to equity exposure, while helping to dampen portfolio volatility. It’s also worth remembering that high-yield bonds are less risky than equities, since bondholders get paid before shareholders in the case of liquidation or bankruptcy. In an age when many equity investors are seeking ways to reduce the risk in their portfolios, we think high yield is an alternative worth considering.