Striking a Balance: How Adding High-Yield Bonds Could Ease Equity Volatility

Equity investors concerned about volatility may find solace in a surprisingly versatile investment tool.

Stocks have surged since their April lows, with demand especially high for higher-risk equities and technology stocks—including those issued by firms with unproven profitability. But economic growth is slowing, and trade-related uncertainty has yet to be resolved. For investors looking to rebalance portfolios or dial down portfolio risk, we believe high-yield bonds could be a compelling complement to equities.

High Yield: A Potential Path to Lower Overall Volatility

Equities have been on an undeniable hot streak. The tech-heavy NASDAQ has surged by more than 20% over the past year, fueled in part by enthusiasm about artificial intelligence (AI). With its potential to shore up productivity and rein in costs, the possibilities of AI seem endless. But while corporate AI adoption rates are on the rise, the extent to which firms can turn AI’s promise into profits is unclear. In our view, some equity valuations may be stretched.

Investors looking to remain in stocks but rotate out of higher-risk holdings typically look to rebalance into investment-grade bonds. Government bonds and high-quality credit assets do have their place in a diversified portfolio, but we believe high-yield corporate bonds warrant a closer look—particularly in today’s market.

Within the context of fixed income, high-yield bonds aren’t typically associated with lower risk. But as a complement to equities in an overall asset allocation, high-yield bonds can reduce portfolio volatility. Here’s how.

Over extended periods, high yield has historically generated equity-like returns with significantly less risk. Since 2000, the Bloomberg US Corporate High Yield Index posted an average annual return of 7.6%, with an average annual volatility of 7.1%. During this same period, the S&P 500 gained on average 9.8% but with a volatility of 13.8%—about twice that of high yield (Display, left). This dynamic is especially powerful in challenging markets when, historically, high yield has captured just 44% of equity drawdowns (Display, right).

By shifting a portion of their equity holdings into high yield, investors could meaningfully reduce their overall volatility while conceding relatively little in return. What’s more, we think the return and volatility relationship between high yield and equities may be even more compelling than usual today, thanks to a combination of elevated yields and slow economic growth.

The Cherry on Top: Elevated Yields, Slow Growth

Yields remain elevated despite the Fed’s renewed monetary easing campaign. Currently, the high-yield sector’s yield to worst is 6.7%—a historically high number. Elevated yields can provide an attractive income component to a growth-oriented strategy. But that doesn’t mean sacrificing growth potential. In fact, yield to worst has historically been a reliable proxy for five-year forward returns (Display). 

Today, we believe that investors who opt to replace higher-risk equities with high yield may be able to achieve long-term returns on par with or greater than the equities they’re replacing. Historically, high yield has outpaced equities in lower-growth environments, such as the one we’re entering today (Display, left). And historically, high price/earnings multiples like today’s have correlated with below-average return for stocks (Display, right), validating investor worries about stretched valuations. Given increasingly sluggish demand and diminished global trade, the timing could be just right, in our view, to deploy high yield.

Investors concerned about spreads shouldn’t have much to worry about either, in our analysis. While spreads are tight, yields are still high, and spreads comprise a smaller portion of yield. Moreover, the high-yield credit universe is relatively healthy, in our analysis, and investors can move up in quality from BBs to BBBs without sacrificing much in the way of yield.

A Versatile Tool for Challenging Times

Investors considering rebalancing should be aware of the risks—particularly in a market as varied and complex as high yield. Especially among lower-rated bonds, credit downgrades are outpacing upgrades, while interest-coverage ratios and EBITDA margins have deteriorated. Active managers skilled at managing credit risk can navigate the crosscurrents of shifting fundamentals and tighter credit conditions to avoid the names most vulnerable to default.

Equities remain an integral part of a balanced investment portfolio. But in our view, high yield can help de-risk equity allocations while generating income and preserving the potential for higher long-term returns. Investors looking to rebalance or reduce portfolio volatility after a strong run for equities could have a powerful tool in the form of high-yield bonds.