A Multi-Asset Perspective on High Yield
Key Insights
- High yield spreads and equities have a strong relationship as both are closely tied to the business cycle and financial conditions.
- Historically, as spreads widened, forward returns for high yield became more attractive relative to a basket of equities and Treasuries with similar risk.
- Investors potentially could improve portfolio risk/return profiles by allocating to or from high yield when spreads are especially wide or tight.
High yield bonds provide many benefits to multi‑asset investors, warranting a strategic allocation in a diversified portfolio. However, while many, if not most, multi‑asset investors now have dedicated high yield allocations, what we’ve found to be less common is a process for allocating to or away from high yield bonds in environments that appear particularly favorable or unfavorable relative to a basket of U.S. Treasuries and equities with similar characteristics.
The analysis that follows suggests that investors who take a “set it and forget it” approach to their high yield allocations may be forgoing opportunities to generate additional returns and/or manage downside risk when spreads become historically wide or tight.
High Yield Bonds: A Total Portfolio Perspective
High yield bonds often are regarded as a hybrid of equities and investment‑grade (IG) bonds because they share common characteristics with those assets. Relative to IG bonds, they offer meaningfully higher yields. The additional yield spread over Treasuries compensates investors for the weaker balance sheets and higher default risks of high yield‑issuing companies. In addition to having favorable characteristics as a standalone asset class, high yield bonds also provide other potential benefits to investors:
- Relative to equities, high yield bonds sit higher up in the capital structure and, like IG corporates, provide capital structure diversification.
- High yield benchmarks provide industry, factor, and company‑specific diversification that changes over time based on issuance trends rather than the relative equity performance that drives changes to equity benchmarks that are weighted by market capitalization.
- High yield bonds provide meaningfully higher income or carry relative to most asset classes. While this is particularly beneficial to income‑focused investors, it is also beneficial to total return investors, particularly when other asset classes are range‑bound and income makes up a larger portion of the total portfolio return.
We think it is critical for asset allocators to think about diversification not only by asset class, but also by common factors when they are constructing portfolios.
We think it is critical for asset allocators to think about diversification not only by asset class, but also by common factors when they are constructing portfolios. A relatively simple approach to looking at asset class factors at the total portfolio level is to decompose each asset class into the two primary factors that explain most of the return: interest rates (i.e., Treasury yields) and equities. We believe this approach is particularly suitable for analyzing high yield bond returns for two reasons:
- High yield bonds are often quoted and analyzed based on interest rate spreads over Treasuries, such that the total yield and return can easily be decomposed between Treasuries and spreads.
- Like equities, high yield spreads serve as a barometer for future corporate profits, and, therefore, the returns each generate are highly correlated with one another.
Important Information
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of May 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
T. Rowe Price Investment Services, Inc.
© 2020 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the bighorn sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc.