Since 1983, High Yield Has Produced +90% of the Return of Equities with Roughly Half the Risk

High Yield Has Produced +90% of the Return of Equities with Roughly One-Half the Risk

Return & Volatility of High-Yield Bonds & Stocks

Sources: Strategic Insight, as of December 31, 2012. Data from June 1983 through December 2012. Past performance is historical and does not guarantee future results. High Yield is represented by the Barclays Capital US High Yield Credit Index; Stocks are represented by the S&P 500 Index.

High Income
Relative to traditional fixed income sectors, high yield bonds offer substantially higher income.

While these bonds generally have lower credit ratings, they're also LESS sensitive to changes in interest rates. 

This means their price is LESS likely to decline when interest rates and inflation rise, two environments in which traditional fixed income sectors suffer.

This makes the high-yield sector an exceptional hedge and an uncorrelated diversifier for your portfolio.



Best of Both Worlds
High yield securities combine the best characteristics of stocks and bonds.

In fact, high yield bonds have historically generated long-term total returns similar to equities with almost half the volatility.

When compared to traditional fixed income sectors, high yield bonds have provided greater returns, albeit with additional volatility.

This distinct risk/return dynamic makes for a compelling, strategic long-term allocation.

Short-Term High-Yield Bonds Offer Relatively High Yields With Lower Volatility

High-Yield Bonds & The Historical Impact of Rising Interest Rates...

Even at historical low yields of about 7%, high-yield corporate debt stacks up favorably against the S&P 500, which has a dividend yield of less than 2%. That means stocks, which are a lot more volatile than bonds, would need to gain at least +5 percentage points of performance just to keep up with a more predictable 7% yield from high-yield bonds.

Historically, high-yield bonds have not been as sensitive to interest rate increases as investment-grade bonds and treasury bonds.

For example, one of the biggest threats to fixed income right now is that a sudden spike in interest rates — currently at historic low levels — would further wipe out returns. According to an analysis of the biggest interest rate moves over the 20-year period through June 2006, high-yield bonds are remarkably resilient against interest rate volatility.

Between September 1987 and June 2006, there were six separate 12-month periods that saw the yield on the 10-year Treasury climb by between +117 and +222 basis points.

The average total return of high-yield bonds for those same 12-month periods was +5.5%, with just one negative-return period.

In comparison, the average total return for investment-grade corporate bonds over the same periods was a loss of -0.1% ,  including three negative-return periods.

Of the six 12-month periods, the worst performance for high-yield bonds was a decline of -1.57% in 1994, when the Treasury yield climbed by +204 basis points. Over the same period, investment-grade bonds fell by -3.34%.

The best 12-month period for high yield was through May 2004 when the bond category gained +13.23% on a 130-basis-point gain in the Treasury yield. Investment-grade bonds over the same period fell by -0.47%.

One of the main reasons high-yield bonds are able to weather interest rate volatility is the yield “cushion,” according to Sabur Moini, manager of the $1 billion Payden High Income Fund (PYHRX). For example, the current 6.8% average yield on high-yield bonds compares with a 3.8% average yield on investment-grade bonds.

“The bigger yield cushion makes high-yield bonds a lot less interest-rate-sensitive,” Mr. Moini said.

“Typically, low growth, but not in a recession, is the best environment for high-yield bonds,” said Michael Collins, co-manager of the $700 million Prudential Total Return Bond Fund (PDBAX). A little bit of inflation and projected economic growth in the +2% to +2.5% range “is almost the sweet spot for high yield,” he said.

High-Yield Bonds Hit Record...

Junk bonds closed out a record-setting August and look poised to resume their bull run in September, despite—and because of—persistently weak returns and outlooks for other asset classes.

August saw $23.0 billion in high-yield bond issuance, according to data provider Dealogic, the 7th-largest monthly volume on record. The performance was remarkable because August has historically been a relatively quiet month, and because no junk bonds priced during August's final 10 days.

After holding firm in July and early August, corporate bonds faded late in the month, losing some value in thin secondary market trade. A market respite is normal during peak late-summer vacation season, but this one also coincided with the worst August for equity markets since 2001.

Junk bonds, which often move in tandem with stocks, now are tasked with regaining their momentum in September—historically the worst month of the year for equities—and October, the second worst.

Despite how far junk bonds have come—returning +57% in 2009 and +8.3% in 2010 to date, according to Merrill Lynch—investors still see the potential for further gains.

"Considering the continued improvement in corporate balance sheets and how much demand there's been for high yield, there's still a lot of value in the high yield market," said Gibson Smith, fixed-income portfolio manager at Janus Capital Group.

Fund managers such as Mr. Smith cite current average high-yield risk premiums of +6.9 percentage points above Treasurys, more than a full percentage point higher than historical norms, and say that could shrink further without getting out of line with default expectations, even while underlying Treasury rates bounce along near historic lows.

The economy keeps struggling, but fixed-income market participants point out that their asset class is less reliant on growth than equities in order to produce solid returns.

"The last several weeks there's been a lot of press given to the weak economic data and slowing growth numbers, and that's led to a downturn in equities," said Jim Merli, head of debt distribution and origination at Nomura Securities. "We're of the view that we are going to see relatively modest growth at a level which will be positive for the credit markets."

Junk Bonds Jump Back To 2007 Levels

High-yield debt approaches par for the first time since before the crisis.

The riskiest class of corporate bond has inched close to par for the first time since 2007. The high-yield bond market now trades at 99.48 cents on the dollar, according to a Bank of America-Merrill Lynch Index, its highest price since the financial crisis hit in 2008. Hitting par (100.00 cents on the dollar), or face value, is a reflection that investors think they have little to fear.

The last time the market traded at par was June 11, 2007. When credit markets collapsed after the fall of Lehman Brothers, the typical high-yield bond bottomed out at 54 cents on the dollar in December 2008.

"The (high-yield) market is definitely indicating that the economy is on a solid footing," says Martin Fridson, head of Fridson Investment Advisors in New York. "You can't rule out entirely a slide back into recession, but the likelihood of that has diminished significantly."

High-yield bonds have rewarded investors with a +49% return in the past 12 months and +6.8% so far this year. Fridson says the market's surprisingly quick rebound since the financial crisis is a testament to the Federal Reserve's efforts to revive credit – keeping benchmark lending rates near zero while mopping up mortgage bonds and other securities considered toxic. "You got two years of returns in one year," he says.

 Bank of America's high-yield index currently pays an 8.1% yield. Over the last 20 years, the yield has dropped below 8% for a total of 28 months, Citigroup's strategists say, and has never sunk below 7%.

High-Yield Bonds Continue To Outperform

Over the past month or so, the only area of the bond market that has done well is junk.

  

Both Treasuries and investment grade corporates have struggled, while high yield bonds have continued to surge.

Below we highlight a 6-month performance chart of the high yield bond ETF (HYG) and the investment grade corporate bond ETF (LQD).

As shown, HYG is up +18.2% over the last six months, while LQD is only up +5.5%.

You can see a clear split in performance (shaded in gray) at the start of December, where HYG continued to trade higher and LQD began to trade lower.

Chart and analysis courtesy of Bespoke Investment Group