Searching for Yield? Making a Case for High-Yield Bonds

When COVID-19 first rocked the financial markets in March, most investors were focused on the carnage in the stock market. But I took a different approach.

During this period, I advised my clients with a high tolerance for risk to consider one move: to swap approximately 10% to 15% of their high-quality bonds for high-yield bonds. Although I was confident the shift would result in a favorable outcome looking out a year or more, the move has paid off much quicker than anticipated. High-quality bonds have only inched up slightly over the past six months, whereas high-yield bonds have gained approximately 15%.

A Small Slice of Your Portfolio

Admittedly, while the case for continuing to buy high-yield bonds isn’t as compelling today as it was in March, I believe they can still be a valuable component of an investor’s portfolio. For an investor with a traditional portfolio of 60% stocks and 40% bonds — but without these securities — it may make sense to trim a small percentage from both instruments and place 5% to 15% of a portfolio in these bonds.

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I realize that many people may find this strategy puzzling. It’s unclear if our economy will continue to recover, and plenty of large corporations in the hospitality and airline industries are facing tough times. Many investors believe these bonds are just too risky under any circumstances. After all, isn’t that why high-yield bonds as sometimes referred to as junk bonds?

But, if used properly, high-yield bonds can be a complementary component of a more conservative bond allocation. While certainly riskier than U.S. Treasury bonds, working with an active high-yield manager can help make these investments work.

A Look at Performance over the Years

While past performance is not a guarantee of future investment results, history is on the side of high-yield bonds when compared to a more traditional stock and bond investment strategy. For example, since 2000, the Barclays US Aggregate Bond Index — core bonds — had a probability of loss of 0% over trailing three-year rolling periods. Over the same period, stocks (S&P 500) delivered a loss 22% of the time. High-yield bonds lost money less than 4% of the time.

As for the annualized return during the past 20 years? Core bonds have gained 5.2%, stocks 6.4% and high yield-bonds 6.9%. High-yield bonds were the best performer with only slightly more long-term risk than more conservative core bonds. (Note: Investors cannot invest directly in an unmanaged index.)

Don’t Ignore the Risks

Make no mistake, there certainly are risks. Investors must be willing to handle above-average, short-term volatility. These securities can experience major swings in price on a daily and monthly basis — similar to the stock market — and easily create the perception they offer equity-like volatility, with bond-like returns. For those willing to take a longer-term view, the opposite is closer to reality.

2 Reasons to Consider This Strategy

Here is why it may make sense for an individual investor to place a small portion of their portfolio in high-yield bonds:

Stocks and High-Grade Bonds Face Obstacles. Thanks largely to the Federal Reserve’s intervention and the federal government’s stimulus programs, the stock market has made a remarkable recovery since March. However, by nearly all measures, it has a high valuation. As of Nov. 1, the Standard & Poor’s 500 Price to Earnings Ratio (P/E) stood at 34 — much higher than historical levels. Fixed income yields are still at rock bottom, around 1% to 2%. Meanwhile, high-yield bonds are yielding about 6%.

The Federal Reserve is Here to Help. With the Fed pledging to keep interest rates at nearly 0% for the foreseeable future, there may be an opportunity for high-yield investors. While some companies issuing high-yield bonds look shaky, as a bond investor, you simply need to know one thing: Can they pay their bills and weather the storm? Here’s a good example.

After the coronavirus shocked the cruise industry, Carnival Corp., owner of Carnival Cruise Lines, saw its revenues plummet. But it received a lifeline from banks after the Fed, in late March, unveiled an intervention strategy to begin lending operations to unclog corporate debt markets.

When Carnival officially sold $4 billion of bonds on April 1, it had enough demand to cut the interest rate down to 11.5% and also issued a $1.75 billion bond that could convert into stock, according to The Wall Street Journal.

These investors — now earning 11.5% — believe the cruise line business will gradually begin to return in 2021. However, even if the company goes bankrupt, some investors holding these high-yield bonds now own a potential piece of the company’s equity, as well as its cruise ships.

Work with an Active Investment Manager

I strongly recommend that any investor deciding to include high-yield bonds in their portfolio works closely with an investment professional to choose their investments. Instead of buying an exchange-traded fund or an index fund, we prefer active management.

These professionals have the ability to perform credit analysis and identify strong candidates for investments in this more obscure segment of the financial markets. Utilizing a portfolio manager with significant expertise and experience in this area can make this asset class attractive.

High-yield bonds may be one of the most misunderstood financial asset classes. But, used properly, they can produce steady returns that can complement a traditional stock and bond portfolio. For investors concerned that the ultra-low interest rate environment may foreshadow lower returns for all assets, those willing to expose a portion of their portfolio to a higher level of short-term volatility may want to give them a look.