Fixed income is an important component of a balanced portfolio. The problem many investors and advisors face today is where do you find yield in this environment and what happens to your fixed income exposures should rates rise? Where can you go in the fixed income sector?
A traditional balanced portfolio often includes some sort of corporate bond component, and often the focus is on investment grade bonds. However, we believe that investors should additionally consider high yield corporate debt as part of their corporate fixed income component. Even accounting for the traditionally higher default risk, high yield bonds have outperformed investment grade bonds over the past twenty five years.1
While defaults are a consideration when evaluating the corporate bond space, the forward default outlook for the next several years shows projected defaults to be well below average, indicating a more benign default environment for high yield bonds as we look forward.2
We would see a generally positive fundamental environment for corporate credit on this front.
On the interest rate front, investment grade bonds carry a much longer maturity and lower yield, in turn making their duration (a measure of interest rate sensitivity) much longer, at about 4 years for high yield bonds versus 7.3 years for investment grade.3
The vast majority of high yield bonds are issued with maturities ranging from 5-10 years, while investment grade bonds often have maturities well beyond that range. This puts the average maturity of the high yield index at just over 6 years while the average maturity on the investment grade index is 4.5 years longer, closer to 11 years.
Additionally, investment grade returns historically have been very negatively correlated with changes in Treasury yields, while high yield bonds have been positively correlated.4
This means that if your concern is rates will rise, which in turn will cause the yield on government bonds (5- and 10-year Treasuries) to increase, then historically, returns on investment grade bonds have decreased, thus the negative correlation. On the flip side, the positive correlation between high yield and Treasuries would indicate that as yields increase in Treasuries, we have historically seen positive returns in high yield bonds. The historical data shows that high yield bonds have actually performed well in periods of rising rates (see our writings “Strategies for Investing in a Rising Rate Environment” and “The Election Impact on the High Yield Market: Rates and Regulation”).
As we look at the fixed income sector, we believe that high yield bonds are a viable investment choice in today’s market relative to investment grade bonds. Investment grade debt carries a much longer maturity and a much higher duration, meaning more interest rate risk should we see rates rise. In addition, the coupon income and yield is much higher for high yield bonds, as indicted by the charts above. Those looking for some yield generation for their fixed income debt allocation and less interest rate exposure should take a look a high yield corporate debt.