High-Yield Bonds: Equity-Like Returns with Lower Risk

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. 

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.

High Yield: Equity Like Returns with Lower Risk

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.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Douglas J. Peebles

Chief Investment Officer—AllianceBernstein Fixed Income
Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer and Head of AllianceBernstein Fixed Income. In this role, he supervises all of the Fixed Income portfolio management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within Fixed Income, including director of Global Fixed Income from 1997 to 2004 and co-head of AllianceBernstein Fixed Income from 2004 until 2008. He holds a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

Gershon M. Distenfeld, CFA

Director—High Yield
Gershon M. Distenfeld is Senior Vice President and Director of High Yield, responsible for all of AllianceBernstein’s US High Yield, European High Yield, Low Volatility High Yield, Flexible Credit and Leveraged Loans strategies. He also serves on the Global Credit, Canadian and Absolute Return fixed-income portfolio-management teams, and is a senior member of the Credit Research Review Committee. Additionally, Distenfeld co-manages the High Income Fund and two of the firm’s Luxembourg-domiciled funds designed for non-US investors, the Global High Yield and American Income Portfolios. He has authored a number of published papers and initiated many blog posts, including “High Yield Won’t Bubble Over,” one of the firm’s most-read blogs. Distenfeld joined the firm in 1998 as a fixed-income business analyst. He served as a high-yield trader from 1999 to 2002 and as a high-yield portfolio manager from 2002 until 2006, when he was named to his current role. Distenfeld began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. He holds a BS in finance from the Sy Syms School of Business at Yeshiva University and is a CFA charterholder. Location: New York

Ashish Shah

Head—Global Credit
Ashish Shah is Head of Global Credit and a Partner at AllianceBernstein. He is also a member of the Absolute Return portfolio-management team. Prior to joining the firm in 2010, Shah was a managing director and head of Global Credit Strategy at Barclays Capital, where he was responsible for the High Grade, High Yield, Structured Credit and Municipal Strategy Groups, and the Special Situations Research team. Prior to that, he served as the head of Credit Strategy at Lehman Brothers, leading the Structured Credit/CDO and Credit Strategy Groups and covering the cash bond, credit derivatives and CDO product areas for global credit investors. Before that, Shah served as North American CFO at Level 3 Communications from 1999 to 2000 and gained trading experience at Soros submanager Blue Border Partners and at Bankers Trust, where he ran US equity arbitrage from 1994 to 1999. He holds a BS in economics from the Wharton School at the University of Pennsylvania. Shah has long been committed to diversity issues and has led several key diversity-related initiatives across the firm. Location: New York

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