As 2023 draws to a close, the year may be remembered by bond investors as one in which they could once again access attractive yields in fixed income securities without taking on undue risk. Yields on short-term Treasurys and money market funds reached 5% or more.
For investors who can tolerate a higher level of risk in their bond portfolios, even more compelling yields have become available in the high-yield bond market. These are bonds issued by companies with below-investment-grade credit ratings, and so may have higher volatility and a higher risk of default or downgrade than investment-grade bonds (learn more about bond ratings).
Although high yield is often thought of as a niche asset class, its long-term risk-reward profile might earn it a second look from some investors. To be sure, past performance is never a guarantee of future results. But over the 20-year period from October 2003 to September 2023, high-yield bonds tied with US stocks in delivering the highest risk-adjusted returns of all major asset classes, according to Fidelity research.1
High yields, reasonable valuations, and strong fundamentals
Dig deeper into the asset class, beyond those yield figures, and investors may also find a relatively attractive setup.
For high yield, valuation is primarily measured by spreads—i.e., how much additional yield, over and above Treasurys, an investor can earn with the asset class. A higher spread means investors can earn more yield for taking on that additional credit risk, and so implies a cheaper valuation (as a low price-earnings ratio would imply for stocks). Recently, valuations have been reasonable, though not cheap—with the yield spread over 10-year Treasurys slightly lower than the historical average, at about 4.4 percentage points as of the end of October.
But Benjamin Harrison, co-manager of Fidelity® High Income Fund (
Other measures help paint a picture of an asset class where credit quality has dramatically improved in recent years. For instance, leverage among high-yield issuers (meaning how much debt they carry) is at its lowest level in more than a decade, according to some measures.3 Companies are in relatively strong positions to service their debt, as measured by ratios of income to interest expense.4 And there's a relatively low proportion of debt coming due in 2024 and 2025—which could help reduce the risk of conditions deteriorating if issuers have to refinance maturing debt at higher rates.
Finally, because so few bonds have been issued in the past 2 years, the market is not oversupplied, which could help provide a "technical tailwind," says Scott Mensi, a Fidelity institutional portfolio manager.
A focus on risk management
High-yield bonds generally face less interest-rate risk than their investment-grade counterparts—meaning that, all else equal, they suffer smaller price losses when interest rates rise. (Investors can compare interest-rate risk by looking at a bond or bond fund's duration.)
But credit risk is higher. That can mean a higher risk of default, but also a higher risk of price volatility if investors become nervous about credit conditions. Understanding and balancing those credit risks can take deep research into issuers. For example, the Fidelity High Income Fund draws on a dedicated team of analysts, divided by sector, who research 600 or more companies on a bottom-up basis. For this reason, most investors would be better served by investing in a high-yield portfolio managed by pros, rather than attempting to build their own portfolio of individual high-yield bonds.
The 2 co-managers "try to be well diversified across sectors, taking industry and issuer over- and underweights when we have conviction," says Harrison. "The fund takes a little more risk than the index in a measured way."
For example, one recent industry of interest has been energy, says Karam, due to the US's advantages in producing liquefied natural gas relatively cheaply compared to the rest of the world. By contrast, he has been cautious of some telecom issuers, due to concerns over competition from wireless and broadband, and certain financial issuers.
High-yield lite
One way to help reduce risk in the high-yield space is to invest in short-duration bonds. Due to near-term maturities and high coupons, these have relatively low volatility compared to longer-dated bonds.
The recent interest-rate environment has been particularly attractive for low-duration high-yield bonds because the yield curve has been flat or even negative sloping—meaning shorter bonds have offered similar or greater yields than longer bonds. "Since the yield curve has been relatively flat in recent quarters, the difference in current yields has narrowed between the 2-year and 4-year duration strategies," says Karam, who, along with Harrison, is also co-manager of the Fidelity® Short Duration High Income Fund (
Potential role in a portfolio
How does this asset class fit into a diversified portfolio? High-yield bonds tend to move more in tandem with stocks than with investment-grade bonds. Naveen Malwal, institutional portfolio manager with Fidelity's Strategic Advisers, says that a small allocation to high yield can play a diversifying role in a long-term multi-asset portfolio.
"Stocks have provided growth potential over time," Malwal says. "Investment-grade bonds have provided income and stability. High yield has been kind of in between those 2 asset classes." Each investor is different, of course, but Malwal says that a low-single-digit allocation to high yield is a common range for Fidelity managed account portfolios for clients with long-term time horizons.
Risks of a negative (or positive) surprise
Of course, high-yield performance may depend on the future performance of the economy, which can never be perfectly predicted.
High yield tends to underperform when the economy heads into recession and stocks head into a bear market, because investors grow worried about rising defaults. That underperformance could be compounded if rates were rising at the same time (such as if inflation began to rise again). On the other hand, high recent yields could help absorb and cushion some amount of price declines in such a scenario.
"The high level of income can provide a strong buffer and helps explain why the risk-adjusted returns have been so good historically," says Mensi.
And of course, there's always the potential for a surprise to the upside. If the long-awaited recession never materializes, or is milder than anticipated, high yield could shine. Says Mensi, "slow growth is the sweet spot."
Ways to invest
Investors interested in incorporating high-yield bonds into their portfolio can research mutual funds,ETFs, and individual high-yield bonds on the Fidelity website. Or, for a more guided approach, investors can consider working with a professional who can help determine whether an allocation to high yield might be suitable to your needs, and devise a managed account to align with your goals, risk tolerance, and time horizon.
