Moreover, when interest rates are rising due to strong economic growth, the economic performance of companies that issue high-yield bonds may improve. As the chart below illustrates, returns for high-yield bonds over the past 10 years have been higher than for investment-grade bonds, but are significantly more volatile.
Annual Returns on High-Yield and Core Bonds
Source: Schwab Center for Financial Research, with data provided by Morningstar, Inc. Asset class performance is represented by annual total returns for the following indexes: Barclays US Aggregate Bond Index (core bonds), Barclays US Corporate High Yield Bond Index (high-yield bonds). Returns assume reinvestment of dividends, interest and capital gains. Past performance is no guarantee of future results.
Fitting high-yield bonds into a portfolio
One of the challenges in fitting high-yield bonds into a portfolio is that, over time, they've historically been more highly correlated with common stocks than with most other bonds. So, for investors with portfolios balanced between stocks and bonds, shifting some bond allocation into high-yield bonds might actually increase the volatility of the portfolio and reduce overall diversification. This is especially true in the recent environment, in which higher risk assets have tended to move together. High-yield bonds have been much more likely to move up and down with the stock market than with Treasury bonds.
Correlation of High-Yield Bonds to Other Asset Classes
Source: Schwab Center for Financial Research with data from Barclays Database and Morningstar, Inc. The asset classes are represented by the following indexes: Barclays U.S. Corporate High Yield Bond Index (high yield bonds), S&P 500® Index (US stocks), Barclays U.S. Corporate Bond Index (investment grade bonds), and Barclays U.S. Treasury Bond Index (Treasury bonds). Correlations are between monthly total returns from September 30, 1997 through March 30, 2012. Correlation measures the degree to which two (or more) variables vary together. Correlation coefficients range from -1.0 to +1.0, where -1.0 is perfect negative, or inverse relationship, and +1.0 is a perfect positive relationship; 0.0 implies no relationship. Past performance is no guarantee of future results.
High Yield Index and S&P 500® Index
Source: Barclays Database US Corporate High Yield Index and Bloomberg S&P 500 Index, daily data as of May 1, 2012.
Individual bonds, index funds, ETFs or active management?
For a high-yield-bond investor, the decision of how to invest is as important as whether to invest. However, due to the elevated risk of default compared to investment-grade bonds, we suggest that all investors diversify among issuers and market sectors.
