How Should Investors Think About High Yield Bond Allocations?

Investors tend to have differing views when it comes to high yield and its potential benefits and risks. Has this asset class earned an enduring place in a strategic portfolio? And what is the best approach to assessing high yield investments?

On a recent episode of our Funds in Focus podcast, we spoke with Associate Investment Strategist Ellen Chenoweth about how to think about high yield in the context of a balanced portfolio, how this asset class has weathered the COVID-19 crisis, and how FlexShares evaluates high yield issuers.

DOES HIGH YIELD HAVE A PLACE IN A BALANCED PORTFOLIO?

While high yield bonds are debt instruments like investment grade and corporate bonds, they’re generally thought of as more speculative and may be associated with higher default rates and greater volatility. It’s true that high yield bonds do tend to come with more exposure to credit risk, but they also typically have less exposure to interest rate risk and higher correlations to broad equity indices. These features set them apart from other fixed income investments—and are the reason why high yield bonds can offer a differentiated source of return.

As such, when thinking about where a high yield allocation could fit in a portfolio, it’s important to look at its risk and return profile. With their higher correlations to equity returns, we think about high yield bonds relative to other risk assets as opposed to less risky debt instruments. As shown below, when compared with the S&P 500, high yield bonds have demonstrated a more attractive risk and return profile over the last 30 years.

High yield vs. equity 30-year annualized risk and return as of 10/30/20

Past performance does not guarantee future results. The referenced indices are shown for informational purposes only and are not meant to represent the Fund. Investors cannot directly invest in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

As these numbers would indicate, we’ve found that including an allocation to high yield sourced from a portfolio’s equity sleeve has historically produced similar returns to a 60/40 equity/fixed income balanced portfolio, but with less risk.

HOW HIGH YIELD HAS FARED DURING THE PANDEMIC CRISIS

The onset of the pandemic crisis dealt a sharp blow across asset classes—and high yield bonds weren’t spared. High yield spreads widened considerably as investors priced in the impact of the sudden halt in economic activity, and liquidity became scarce as investors fled risk assets for safe havens. However, high yield performance and liquidity improved with Fed intervention, responding favorably to a cut in interest rates and rounds of quantitative easing.

The pandemic has also led to an increase in the number of “fallen angels”—or bonds that are downgraded from investment grade to high yield, but most of this activity was concentrated in the March-May time period and has since slowed. Default rates also turned materially higher, most predominantly in the Energy sector, plagued by poor technical and falling demand.

Despite these headwinds, demand for high yield has recovered since the early days of the pandemic, driven by improving economic activity and the renewed search for yield.

HIGH YIELD THROUGH A VALUE FACTOR LENS

As high yield bonds have become more widely adopted in balanced portfolios, we’ve seen overall credit quality increase and income generation decrease. This has ultimately led to deteriorating credit premiums and a reduction in the risk and return tradeoff typically observed in the high yield market.

Advances in quantitative tools and greater data availability allow us to remedy this and focus on value as the key lens through which we evaluate high yield credit. At FlexShares, our contemporary quantitative tools help us identify securities trading below their intrinsic values and that have historically generated attractive levels of income relative to the broad high yield market. This enables us to construct a high yield bond portfolio with higher exposure to credit premia and greater potential for capital appreciation.

Please see our FlexShares High Yield Value-Scored Bond Index Fund (HYGV) for more information on our high yield bond ETF designed to maximize exposure to the value factor.

IMPORTANT INFORMATION 

FlexShares High Yield Value-Scored Bond Index Fund (HYGV) invests in high yield securities, which are considered highly speculative, and is subject to greater credit risk, price volatility and risk of loss than if it invested primarily in investment grade securities. There is a higher risk that an issuer will be unable to meet principal and interest rate payments on an obligation and may also be subject to more substantial price volatility due to such factors as interest rate sensitivity, market perception of credit worthiness of and general market liquidity than if the fund invested in investment grade securities. The fund may invest in distressed securities, which generally exposes the fund to risks in addition to investing non-investment grade securities. These risks can adversely impact the Fund's return and net asset value. When interest rates rise, the value of corporate debt can be expected to decline. The value of the securities in the Fund's portfolio may fluctuate, sometimes rapidly and unpredictably at a greater level than the overall market. The Fund may invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Fund could lose more than the principal amount invested. The Fund will concentrate its investments (i.e., hold 25% or more of its total assets) in a particular industry or group of industries to approximately the same extent that the Underlying Index is concentrated. The fund is also subject to the risk that the Fund's investment in companies whose securities are believed to be undervalued will not appreciate in value as anticipated.