High-Yield Bonds in Focus: Enhancing Modern Portfolio Performance

But what if you could enhance that fact further?

This is where a strategic model allocation to high-yield bonds comes into play. Junk bonds and their high yields can provide similar returns as equities while reducing a portfolio’s volatility and drawdowns. For investors, an allocation to high-yield bonds makes a ton of sense and shouldn’t be ignored.

For most investors, when they think of bonds, they think of investment-grade securities. These include IOUs like Federal Treasury bonds, municipal bonds issued by states like California or Texas, or corporate bonds from Walmart. And in that, they are mostly thought of as an income portfolio element.

After all, when you buy a bond, you are lending an entity money; in exchange, the entity promises to pay you interest and then your principal back at maturity. With default rates on most forms of investment-grade bonds very low to non-existent, the coupon rate can provide a return. Most investment-grade bonds trade near or at par.

But the high-yield market is different.

Created in the 1980s and coming of age during the 1990s, high-yield or junk bonds are issued by firms with less than investment-grade credit ratings. Default risks are higher—between 3% to 5% during normal conditions and as high as 8% during economic duress—and, as such, most junk bonds pay rates that are nearly double safe Treasuries or investment-grade corporate bonds.

Unlike Treasury or other investment-grade bonds, high-yield bonds tend to see their prices shift up and down. Bonds that sink in the credit ratings or as default risks rise can see their values swing wildly. The volatility of high-yield bonds is roughly double that of U.S. Treasuries.

Because of this, many investors look toward junk debt as a source of total return. The focus is both on yield and price appreciation when the bond finally matures or sees changes in its value.

That’s a key distinction.

Because junk moves up and down, and provides a high yield, it creates a very different return matrix than other forms of fixed income. And since the yields for junk are in the 7% to 9% range, the combination provides very equity-like returns.

But remember, these are still bonds. So, there are still some expectations investors will get their principal back or, in the case of a default, some of it back. Bonds—even junk bonds—sit high above stockholders on the bankruptcy ladder. Assets, cash on hand, etc. can and are sold during bankruptcy proceedings to pay back lenders—the bondholders—before equity owners get anything back.

All of this creates a high rate of return with low risk. This chart from asset manager Fidelity shows the high returns junk bonds have while having lower standard deviations in their returns. While equities may have higher returns, they bounce around more than high-yield bonds.

Source: Fidelity

This relationship of strong returns but less volatility can be a great tool for investors to exploit in a model portfolio. Volatility is a major issue for the longevity of returns and can lead to something called volatility decay. That’s because it takes higher gains to break even again after a loss. The more an asset class bounces around, the greater the chance of losses.

But with junk bonds, you can get strong equity-like returns while reducing the bounciness. Their high yields provide a cash return that is near equity total return levels. BlackRock has some data to support this. The main high-yield bond benchmark—the Bloomberg U.S. Corporate High Yield Index—has managed to capture 50% of the upside of the S&P 500, while only realizing about 29% of the downside. ¹

For a model portfolio, this is a huge win.

Rather than consider high-yield bonds as a fixed income component―which is how most investors look at them—they should serve as an equity replacement or complement. Rather than token allocation to simply boost yield, they should be given a main weighting. A strategy that combines larger allocations to high-yielding bonds with smaller allocations to stocks can serve as a great way to grow a portfolio with less volatility and bounciness than simply owning stocks alone.

As for that allocation, the bigger the better. In fact, some analysts have proposed junk be given a much larger weight than equities, with stocks filling in as the niche player. However, as little as a 5% to 10% weighting in high-yield bonds can do a portfolio wonders in smoothing out returns and reducing volatility, according to State Street.

Given the potential for high-yield bonds to smooth out returns, lower volatility, and provide equity-like gains, adding them to a model portfolio as a strategic allocation makes a ton of sense. Investors and financial advisors using an SMA format can certainly add individual bonds. But like most of the fixed income world, junk can be hard to own with these securities trading on the over-the-counter-bulletin-board (OTCBB).

Instead, a model portfolio’s best friend, the humble exchange-traded fund (ETF), could be a great bet. And thanks to the ETF boom, there are many different ways to get that fix. There are plenty of passive index funds that track broad high-yield indexes.

Another approach could be to go active or add some active muscle to a larger passive holding. As with many bond sectors, the inefficiencies in the high-yield market are easy for managers to exploit. This can lead to higher returns and even lower volatility.

These funds were selected based on their exposure to junk bonds. They are sorted by their one-year total return, which ranges from 10% to 13%. They have expenses between 0.05% and 1.02% and assets under management between $0.55B and $15.2B. They are currently yielding between 4.8% and 8.4%. 

In the end, the goal of model portfolios is to create a strong asset allocation that reduces volatility and boosts returns. And investors can have that in junk bonds. Their high cash coupons and placement in the bankruptcy ladder can have them performing like equities with lower risks. Using them as a stock replacement or adding a strategic allocation that is meaningful can do wonders for risk reduction and portfolio returns.

Junk bonds are not like regular bonds. That’s a great thing when it comes to building a model portfolio. The high-yield market can provide stock-like returns with much less risk. With that in mind, adding an allocation to junk makes sense in a model portfolio to smooth out returns and reduce risks.

¹ BlackRock (October 2024). Unlocking income potential in high yield bonds