Fixed Income | June 16, 2016

High-Yield Bonds: Why "Risky" Asset Classes Can Help Diversify Risk

In today's more interconnected investment markets, advanced diversification models require more than just core stocks and bonds. Within fixed income, high-yield bonds can help enhance diversification. But sometimes investors who don't know much about high-yield bonds—other than that they're often called "junk" bonds—might think they're too risky to even consider.

Junk bonds are riskier than some other bonds, but as you might expect, with greater risk comes the potential for higher yields and better expected returns. As Figure 1 shows, high-yield bonds have historically outperformed Treasuries over time while exhibiting less volatility than stocks.

Figure 1: High-yield bonds have delivered higher returns than Treasuries, less risk than stocks

Asset class Annualized return Annualized volatility
U.S. large-cap stocks 8.2% 15.3%
High-yield bonds 6.8% 9.1%
U.S. Treasuries 5.0% 4.4%

Source: Morningstar Direct, based on 20 years of monthly total returns from 1/1/1996–12/31/2015. Indexes used for each asset class are U.S. large-cap stocks, S&P 500® Index; high-yield bonds, Barclays U.S. Corporate High Yield Bond Index; U.S. Treasuries, Barclays U.S. Treasury Bond Index.

Asset classes that might appear risky on their own can potentially enhance diversification in a portfolio if they don't move in lockstep with other asset classes—a measure called correlation. High-yield bonds have historically delivered this diversification due to moderate correlations with stocks and low to negative correlations with Treasuries.

By including a small allocation to high-yield bonds, a portfolio can target higher expected returns over the long run without overconcentrating in even riskier stocks. High-yield bonds also help diversify bond risk in a portfolio because their credit risk makes them less sensitive to rising interest rates than Treasuries.

High-yield bonds have helped diversify equity risk

High-yield bonds have a reputation for behaving a lot like stocks—but in fact, high-yield bonds have outperformed stocks in recent stock market corrections. As Figure 2 shows, during the market correction in mid-2015, high-yield bonds declined less than one-quarter as much as the S&P 500 Index. And during the severe stock market declines of 2008-2009, high-yield bonds fell about half as much as stocks.

Figure 2: High-yield bonds have outperformed stocks during stock market corrections

U.S. stocks correction U.S. stocks return High-yield bonds return
10/10/2007–3/9/2009 -55.2% -28.6
5/2/2011–10/3/2011 -18.6% -7.3%
7/21/2015–8/25/2015 -12.0% -2.8%

Source: Morningstar Direct. Indexes used for each asset class are U.S. large-cap stocks, S&P 500® Index; high-yield bonds, Barclays U.S. Corporate High Yield Bond Index.

High-yield bonds have helped diversify fixed income risk

In the world of fixed income, there are several varieties of risk. Two big ones are credit risk, which is the risk that the issuer of the bond will default, and interest rate risk, which is the sensitivity of the bond's price to changes in interest rates. High-yield bonds have higher credit risk but lower interest rate risk—unlike Treasuries, which have the reverse.

In recent periods when the prices of long-term Treasuries fell more than 10%, high-yield bonds have outperformed. They declined about half as much as Treasuries during the "taper tantrum" of 2013 (when interest rates rose sharply after the Fed announced it would scale back its bond-buying program). And during Treasury market pullbacks in 2008 and 2009, high-yield bonds actually moved in the opposite direction and delivered positive returns.

Figure 3: High-yield bonds have outperformed Treasuries during bond market corrections

U.S. Treasuries correction U.S. Treasuries return High-yield bonds return
3/18/2008–6/13/2008 -4.6% +6.2%
1/16/2009–6/10/2009 -6.4% +24.7%
5/3/2013–9/5/2013 -4.5% -2.4%

Source: Morningstar Direct. Indexes used for each asset class are U.S. Treasuries, Barclays U.S. Treasury Bond Index; high-yield bonds, Barclays U.S. Corporate High Yield Bond Index.

Not all high-yield bonds are created equal

High-yield bonds come in various flavors, with some "junkier" (i.e., carrying lower credit ratings) than others. Bonds at different credit grades can perform very differently. For example, during the volatility of the second half of 2015, the junkiest bonds had double-digit declines, while less junky ones had smaller single-digit declines.

Schwab Intelligent Portfolios® favors those "less junky" bonds. Our primary high-yield bond ETF invests in short-term bonds at the higher end of the credit quality scale within high yield. These bonds tend to have relatively moderate credit risk and low interest rate sensitivity. Your portfolio's allocation to high-yield bonds may range from 0% to 8%, depending on your risk profile.

High-yield bonds are just one asset class among up to 20 that we include in any portfolio, illustrating how our decades of expertise in asset allocation and ETF selection can help enhance the diversification of your investments.

David Koenig CFA®, FRM®, Vice President and Chief Investment Strategist for Schwab Intelligent Portfolios