Adding high-yield and other lower credit-quality securities to a core bond portfolio can potentially increase returns while lowering volatility. Here’s how professional managers can fine-tune that approach for investors.  

As we noted in last week’s Market View, interest rates have continued to defy consensus expectations in 2017, grinding lower and driving positive returns for the broader bond market (the representative Bloomberg Barclays U.S. Aggregate Bond Index [“Aggregate Index”] is up 3.4% year to date through September 14). At the same time, funds in the Morningstar Intermediate-Term Bond Category—many of which are “core” products benchmarked to the Aggregate Index—collectively garnered significant net inflows. Through August 31, the category saw an influx of more than $85 billion in net new money, more than any other category tracked by the fund data provider. Many market observers attribute increased interest in high-quality “core” bond funds to signs of low inflation, safe-haven demand amid tensions with North Korea, and a U.S. fiscal agenda that has not played out as anticipated.

When most investors think of “riskier” segments across the bond market, they consider sectors like high-yield corporates, floating-rate loans, or convertible bonds. Many issuers of these instruments are rated below investment grade by nationally recognized credit rating agencies, suggesting that their debt comes with more credit risk than that of, say, the U.S. government. (In addition to a greater level of credit risk, high-yield bonds also tend to be more volatile than investment-grade bonds.) Through the power of diversification, however, adding lower-quality credits actually may reduce the risk of a high-grade bond portfolio, and might even boost returns while doing so. (Remember that no investing strategy, including diversification, can overcome all market volatility or guarantee future results.)

Truly diversified portfolios combine investments with return profiles that have low, negative, or even zero correlation to each other. A portfolio of securities that “zig” when others “zag” (i.e., tend to perform in the opposite manner) or that have no directional relationship at all can, ultimately, mitigate portfolio volatility as a whole.  For example, the returns of high-yield bonds demonstrated virtually no correlation with those of U.S. government bonds over the five-year period ended August 31, 2017, according to Morningstar. As a result, while high-yield bonds have been more volatile than government bonds over the last five years on an absolute basis, a strategic blend of these two non-correlated asset classes—60% U.S. government bonds and 40% high yield—would have produced a higher return than government bonds alone, with about the same volatility. (Note that these indexes and strategies may not perform in a similar manner in the future.)

Chart 1. Historically, Combining High-Yield Bonds with Government Bonds Has Increased Return without Adding Volatility
Total return and standard deviation for indicated asset classes, September 1, 2012–August 31, 2017

Source: Morningstar. “60% Government / 40% High Yield” refers to specific blend of the Bloomberg Barclays U.S. Government Bond Index and the Bloomberg Barclays U.S. Corporate High Yield Index.
Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Asset allocation does not guarantee a profit or protect against loss in declining markets. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

What happens when we add high yield to a more diversified basket of U.S. investment-grade bonds? Chart 2 shows the performance impact of adding high-yield bonds in 5% increments to the Aggregate Index over the same five-year period shown in Chart 1. As we begin to add high-yield bonds to the allocation, overall portfolio risk falls, while portfolio return rises. Once we exceed a 10% allocation to high yield, the level of risk begins to increase; however, even with a 25% allocation to high yield, we would have had a much better risk-adjusted experience relative to the Aggregate Index, as the 75%/25% blend delivered higher returns with similar volatility. Since below-investment-grade bonds have a higher standard deviation than the core-bond benchmark, increasing the allocation to high yield beyond 25% results in higher levels of overall portfolio risk relative to the Aggregate Index. However, absolute and risk-adjusted returns (as calculated by Morningstar) increase with each allocation adjustment.

Chart 2. Adding High-Yield Bonds Can Potentially Reduce Portfolio Risk, Increase Return, or Both
Total return and standard deviation for indicated asset classes, September 1, 2012–August 31, 2017

Source: Morningstar. “Aggregate Bond / High Yield” blends referenced in the chart refer to specific combinations of the Bloomberg Barclays U.S. Aggregate Bond Index and the Bloomberg Barclays U.S. Corporate High Yield Index.
Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. Asset allocation does not guarantee a profit or protect against loss in declining markets. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

While some investors may prefer to have no allocation to high-yield bonds in their core portfolio, others recognize the potential risk/reward benefits. How much to add depends, of course, on the investor’s specific risk tolerance and objectives. This is why it is important for asset managers to provide investors with choices when it comes to core bond options.

We’ll offer one more approach to consider: a 60% allocation to the Aggregate Index and a 40% allocation to a blend of credit sectors. This blend broadens the “combo” menu by including investment-grade corporate bonds, high-yield corporates, bank loans, and short-term credit. Chart 3 illustrates the risk/reward benefits of the 60%/40% portfolio relative to the Aggregate Index over the five-year time period depicted earlier, as well as the Bloomberg Barclays U.S. Universal Index, an index similar to the Aggregate, but with added credit risk. Again, a strategic combination of high-quality bonds with lower credit-quality securities historically has produced higher return with less volatility than the Aggregate Index. 

Chart 3. Risk/Reward Benefits of a Blend of Credit Sectors with High-Quality Bonds
Total return and standard deviation for indicated asset classes, September 1, 2012–August 31, 2017

Source: Morningstar. “60% Aggregate Bond / 40% Credit Blend” refers to a specific combination of (1) the Bloomberg Barclays U.S. Aggregate Bond Index and (2) the following combination of indexes (“Credit Blend”): 25% Bloomberg Barclays U.S. 1-3 Year Credit Bond Index, 25% Bloomberg Barclays U.S. Corporate Bond Index, 25% BofA Merrill Lynch U.S. High Yield Master II Index, and 25% Credit Suisse Leveraged Loan Index. 
Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. The historical data are f or illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Summing Up
While assessing the credit quality of individual securities and asset classes is important, it’s essential to view risk at the portfolio level as well. To be sure, an asset class like high yield can display volatility that may be too high for some investors. But adding high yield, or other lower credit-quality securities, to a core bond allocation historically has boosted return without a significant impact on overall portfolio volatility. Potentially, a strategic combination of below-investment-grade securities and core bonds could actually lower the volatility of the portfolio as a whole.