Rethinking High Yield

In high yield specifically, investors tend to think about it as a risky way to play fixed income. But we like to turn that thinking on its head, actually: that you should think about it as a way to de-risk your overall portfolio rather than to re-risk your fixed-income side.

If you look historically, investors tend to lean very heavily into the traditional 60/40 portfolio. And that works well, because as your stock portfolio does poorly, generally your government bonds do pretty well. There’s that negative correlation benefit that helps in your portfolio construction.

But if you actually take out a percentage of your equity exposure and move that into high yield—so rather than take your government bond exposure down, take exposure out of the risky part of your portfolio into high yield—just like stocks, it actually has a negative correlation to Treasury rates.

A traditional 60/40 portfolio generates somewhere about 8.7% annualized returns over the last few decades. If you take 15% out of stocks and put it into traditional high yield, your returns drop, but only to about 8.2%. But the very interesting thing is that your risk and drawdowns improve measurably. Your Sharpe ratio is about 10% better, and your drawdown as a worst-case scenario is about 5% better than the traditional 60/40.

And that’s what we would really recommend that clients focus on in their portfolios today is, firstly, diversification across a lot of different assets. So, if there is an issue in one, it doesn’t cause you too much pain.

And secondly is to really try to dive deeper into “what’s my potential return versus that downside risk.” In high yield specifically, starting yield to worst is something that our market talks about all the time. And if you take starting yield to worst and put a 2% band around it, so 2% higher, 2% lower, what’s the chance that your one-year returns end up within that band versus your starting yield. The results might surprise you.