Asset allocation is a delicate balance for any investor, but it has been complicated by certain factors within the current financial environment, including high equity valuations, the potential for higher interest rates, and the need for some yield in a continued low yield environment. Whether you are in a phase of life where income generation is key or you are putting together a portfolio more focused on generating a total return, we believe there could be a place for high yield bonds within a portfolio.
First let’s look at the high yield bond market from a historical returns perspective. Looking over the past 25 years, we have seen high yield bonds outperform a variety of fixed income categories.1
This performance covers a variety of market environments and cycles. While equities have performed slightly higher on a pure return basis, let’s drill that down in terms of the relative risk. Below, we look at the risk adjusted return (return/risk) for equities versus high yield bonds, using the volatility (standard deviation of returns) as our measure of risk.2
Over the last quarter century, the high yield market has experienced significantly less volatility than equities, as represented by the S&P 500 Index, putting the high yield bond market’s return per unit of risk (return/risk) about 50% higher than the return/risk for the equity index. And we are not just capturing upside volatility, as the high yield bond index’s highest calendar year is much higher than that of the equity index, while the lowest year also fared better for high yield than equities.
We see high yield bonds as a very attractive and viable alternative to complement an equity portfolio. For the more total return-focused investors, much of fixed income carries very low yields and, in many cases, low return prospects, but you likely also don’t want to be 100% investing in equities, especially at these valuations. Thus, we would view a high yield bond allocation as a potential way to generate what we see as attractive yield income within the fixed income space without having to sacrifice return potential.
Turning to the more income-focused investors, a big component of the high yield bond market’s return over the past few decades has been the notable yield/income these securities generate. These are corporate bonds that carry coupons that must be paid semi-annually. While high yield bonds do come with higher perceived risk than then their investment grade corporate counterpart, many munis and governments, we have seen that even accounting for this risk of loss, these bonds have performed better than certain fixed income sectors, as profiled via the 25-year index returns above. But in looking at the high yield market versus these other fixed income asset classes, there is one area where we do see less risk and that is in terms of interest rate risk.
As it has been well-telegraphed that the Fed intends to raise rates this year, investors are left to speculate what that will mean for their portfolio. While we believe that the Fed will not be aggressive with rates and even if they do take a couple of rate increases, we won’t see much impact on the long end of the curve (rather curve flattening), interest rate risk is a very real and valid concern for investors. The high yield market has less interest rate risk as measured by duration and a higher yield, as profiled below.3
There are a number of reasons why high yield bonds currently and historically carry a lower duration/less interest rate risk, including the higher starting coupon income and the fact this asset class is much more tied to credit quality, which improves as economies improve—and rates are generally increasing in periods of economic improvement. Historically high yield bonds have performed well during rising rate environments (for further details and data, see our writings “Strategies for Investing in a Rising Rate Economy” and “The Election Impact on the High Yield Market: Rates and Regulation”).
Not only do high yield bonds benefit from their lower duration/lower interest rate risk, but we believe the higher tangible yield/income they generate is attractive relative to what is available from other fixed income sectors and warrants a look for those investors focusing on income generation. A few rate increases won’t do much to change the low yield environment we are currently in, so the hunt for yield will likely persist. Furthermore, given the historical risk and return profile versus equities, we also believe the high yield market is worth a look for more return-focused investors as an equity alternative. While we have our concerns about the high yield indexes (see our commentary, “The Year of Active Management”), we believe an actively managed high yield bond portfolio can be a viable investment option for a variety of investors in today’s environment.
For information on the AdvisorShares Peritus High Yield ETF (ticker: HYLD), the actively managed high yield exchange traded fund that the Peritus team is sub-advisor to, please visit, www.advisorshares.com/fund/hyld, distributed by Foreside Fund Services, LLC.