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—AB Fixed Income
Douglas J. Peebles is the Chief Investment Officer of AB Fixed Income and a Partner of the firm, focusing on fixed-income investment processes, strategy and performance across portfolios globally. As CIO, he is also Co-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. In addition, Peebles serves as Lead Portfolio Manager for AB’s Unconstrained Bond Strategy, and focuses on managing the firm’s strategic client relationships. In 1997, he pioneered AB’s highly successful and innovative approach to global multi-sector high-income investing, which is now being adopted by other firms. Since joining AB in 1987, Peebles has held several leadership positions, including director of Global Fixed Income (1997–2004), co-head of AB Fixed Income (2004–2008) and Head of Fixed Income (2008–2016). He holds a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

Gershon M. Distenfeld, CFA

Director—High Yield and Investment-Grade Credit
Gershon M. Distenfeld is Senior Vice President and Director of High Yield and Investment-Grade Credit at AB, responsible for overseeing the investment strategy and management of all investment-grade and high-yield corporate bond portfolios and associated portfolio-management teams. Strategies under his purview span the credit and risk spectrum, from short-duration investment-grade corporate bond portfolios to regional and global high-yield portfolios, encompassing a range of investment approaches, objectives and alpha targets, from income-oriented buy-and-hold strategies to active multi-sector total return strategies, and including both publicly traded securities and private placements in developed and emerging markets. Distenfeld also co-manages AB’s award-winning High Income Fund, recently named “Best Fund over 10 Years” by Lipper from 2012 to 2015, and the award-winning Global High Yield and American Income portfolios, flagship fixed-income funds on the firm’s Luxembourg-domiciled fund platform for non-US investors. He also designed and is one of the lead portfolio managers for AB’s Multi-Sector Credit Strategy, which invests across investment-grade and high-yield credit sectors globally. Distenfeld is the author of a number of published papers, including one on high-yield bonds being attractive substitutes for equities and another on the often-misunderstood differences between high-yield bonds and loans. His blog “High Yield Won’t Bubble Over” (January 2013) is one of AB’s all-time most-read blogs. Distenfeld joined AB in 1998 as a fixed-income business analyst, and served as a high-yield trader (1999–2002) and high-yield portfolio manager (2002–2006) before being named Director of High Yield in 2006. He began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. Distenfeld 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

Chief Investment Officer—Global Credit; Head—Fixed Income
Ashish Shah is Chief Investment Officer of Global Credit and Head of Fixed Income for AB. He is also a Partner of the firm. As CIO of Global Credit, Shah oversees all of AB’s credit-related strategies, including all global and regional investment-grade and high-yield strategies. In this capacity, he leads AB’s internal Credit Research Review Committee, the primary investment policy and decision-making committee for all credit-related portfolios managed by AB. As Head of Fixed Income, Shah is responsible for the management and strategic growth of the overall business. He is the author of several published papers and blogs, including those highlighting high-yield bonds as attractive substitutes for equities (June 2015), concerns around the bank loan market (November 2013) and the dangers in reaching for yield in the high-yield market (August 2013). Shah joined AB in 2010 as the firm’s head of Global Credit. Prior to that, he was a managing director and head of Global Credit Strategy at Barclays Capital (2008–2010), where he was responsible for the High Grade, High Yield, Structured Credit and Municipal Strategy groups and the Special Situations Research team. From 2003 to 2008, Shah was 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. He holds a BS in economics from the Wharton School of the University of Pennsylvania. Location: New York

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