- Investment Director
United Kingdom, Intermediary
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Key points:
- High-yield bonds can play a strategic role in a diversified portfolio.
- Beware of assumptions: higher rates are not necessarily bad for long-term capital appreciation.
- In our view, high yield offers attractive opportunities, but we see careful security selection as key for achieving sustained growth.
We believe fixed income investors face a fundamentally different economic era, with new risks but also compelling opportunities. Bonds are now regaining the role they have historically had in portfolios: offering income alongside downside protection and the opportunity for capital appreciation. However, we believe targeting growth in this environment requires a different mindset, challenging some of the assumptions below.
Even with central banks cutting rates, they are likely to remain higher for longer. Isn’t this a bad thing for bonds?
Rates staying higher for longer isn’t necessarily a negative for fixed income investors. Bonds provide higher and more attractive yields, which can be helpful in an environment where investors face so much uncertainty related to geopolitics, inflation and a significant global election cycle.
We believe that higher yields reinforce the positive role of bonds in a broadly diversified portfolio, delivering ongoing income as well as downside protection. Our research suggests that even for a standard 60% equity/40% bond portfolio, income can potentially contribute more than half of the returns over a five-year investment horizon. If investors choose asset classes with a higher income profile, such as credit or high-dividend-income equity, that proportion can increase, reaching as much as 80% in some cases. While a shallower cutting cycle may be more challenging for weaker issuers, it can offer greater opportunities for adding value through careful security selection.
High yield can offer attractive opportunities as a shorter-term trade, but does it make sense as a long-term, strategic allocation?
We believe there is a compelling case to be made for investing in high-yield bonds within a strategic asset allocation.
First, based on historical risk and return characteristics, high yield has the potential to offer comparable returns to equities, but with a lower correlation to equity market beta and better downside protection. Second, given the income-based nature of the return stream, high yield can also offer a narrower set of outcomes relative to equities and therefore an attractive risk and return profile. Finally, high-yield bonds have a relatively low correlation to other fixed income assets, as well as a different sector composition and different risk drivers relative to broad market equities, helping to enhance diversification in a multi-asset portfolio.
All-in yields — a comprehensive measure of a bond’s return — remain very attractive, creating a compelling entry point for clients seeking higher total return potential. In addition to this, high yield tends to have lower duration than other fixed income categories, meaning it is less exposed to rate volatility. Our default expectations are well below previous recessionary peaks, with default rates likely having already peaked. Figure 1 depicts the minimum yield available (yield to worst) for the universe over time, highlighting how, based on the ICE BofA Global High Yield Constrained Index, yields are high relative to history. Spreads have also tightened significantly but remain supported by positive supply/demand dynamics.
Figure 1
With greater volatility likely on the horizon, isn’t high yield too risky?
The investment environment remains uncertain and volatile, so caution is indeed warranted. However, current all-in yields provide a meaningful cushion to investors, and we think the growing differentiation among sectors and regions in the high-yield market is starting to create attractive opportunities for bottom-up focused investors, with Europe currently the standout region.
In this type of uncertain environment, it’s even more important to prioritise companies with sustainable competitive advantages and avoid sectors experiencing increased capacity. These durable competitive benefits can be, for instance, having a cost advantage that is hard to replicate or possessing high-quality intangible assets such as a brand or patent.
When investing in high yield, fundamental research and security selection are crucial, as they can help investors avoid companies with poor credit profiles or those that might be vulnerable to the increased cost of financing in a higher-rate environment.
It’s important to recognise that there are risks to the economic outlook and further volatility is likely. However, opportunities in high yield are emerging, particularly in Europe, provided that investors are willing to do the research and venture into “out-of-favour” areas of the market.
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