Investors often think of high yield as simply the risky asset class within the broad Fixed Income family – the brash cousin who is more tolerable in small doses due to his greater propensity to pass out at the dinner table. However, we should not allow the occasional lapse to overshadow a plethora of positive attributes that distinguish the asset class from its more staid bond market relations.
High yield’s medium and long term correlation (5 year, 10 year, and 25 year, as measured by the JPMorgan Domestic HY Index) to Treasuries has been negative or very low, while for the same time periods, the correlation to equities is above 0.70 (Table 1). These correlations show that high yield returns behave less like bonds and more like equities, which combined with the cushion high yield bonds provide in the case of interest rate hikes (see High Yield Bond Market in a Rising Rate Environment), increases the diversification effect in fixed income portfolios. The positive correlation to equities should not be surprising given that high yield returns are linked strongly to company fundamentals and earnings.
More interestingly, the annual returns in Table 2, show that both U.S. and European high yield bonds performed similarly to equities (data for 25 years are not available as high yield returns don’t exist). The asset class has managed to generate these returns consistently with almost half the equity volatility, which indicates that investors can reduce risk, as measured by volatility, and maintain the level of returns by simply adding high yield bonds in a portfolio. In the worst case scenario for both bond and equity holders, bankruptcy, an investor is better off holding high yield as bond investors are senior in the capital structure vs. equities.
As well as moving investors up in the capital structure, high yield bonds can also enhance the diversification of a portfolio’s corporate risk by expanding the investible corporate universe to well-known but privately owned companies without listed shares. For example, the number of companies that are in both the STOXX 600 and the European High Yield index is just 38. These 38 companies make up 7% of the STOXX 600 on a market cap weighted basis*. Equivalently, 62 companies appear in both the S&P 500 and the U.S. High Yield Index (HUC0). In other words, there are hundreds of companies whose cash flows are only accessible to investors via the high yield bond market.
With credit quality in the high yield market improving, default rates well below the historical average both in the U.S. and Europe, limited correlation to interest rate increases and favourable risk-return characteristics of high yield bonds as discussed above, investors are likely to benefit from an allocation to high yield debt.
*data as of December 2014