5 Reasons to Try Investing in High-Yield Bonds

Investors looking for strong returns often ask: why invest in high-yield bonds? While riskier than traditional bonds, they offer attractive income potential. High-yield fixed-income investments can provide diversification, steady cash flow, and capital appreciation. With the right strategy, investing in high-yield bonds can enhance portfolio performance, especially during uncertain economic periods. Understanding what percentage of a portfolio should be in high-yield bonds is key to managing risk and maximizing gains. 

1. Strong Fundamentals Even in a Slowing Economy

Resilience in the Late Credit Cycle

Economic slowdowns usually lead to weaker corporate fundamentals, but high-yield issuers remain financially strong. Many companies in this sector have spent years strengthening their balance sheets. As a result, their financial health is better than before previous downturns.

During the pandemic, companies managed their debt conservatively, improving leverage ratios and cash flow. This discipline means issuers can better handle economic slowdowns. The default rate is expected to remain between 3% to 4%, lower than past crisis periods.

Higher Credit Quality Than Before

Many investors assume high-yield bonds are dominated by weak issuers. However, the market now has better credit quality than in the past. BB-rated bonds make up 49% of the high-yield sector, compared to a 20-year average of 43%.

Additionally, 87% of the high-yield market consists of BB- and B-rated bonds, which is higher than the historical average of 83%. The 2020 default cycle removed weaker companies, leaving behind stronger issuers with better financial stability.

2. Maturity Runways Reduce Risk

Fewer Upcoming Maturities Mean Lower Default Risks

Some investors worry about the “maturity wall”—a large wave of debt maturing at once. However, high-yield issuers have successfully extended their debt timelines. Only 5% of outstanding bonds will mature by the end of 2024. The majority will come due between 2027 and 2033, giving issuers time to refinance at better rates if needed.

With interest rates expected to decrease, refinancing risks will be lower than feared. High-quality issuers can handle these costs, reducing the chance of mass defaults.

Stable Interest Costs

The average coupon rate for high-yield bonds is 5.8%, while the yield to worst stands at 8.5%. Despite rising interest rates, many companies have locked in lower borrowing costs for years. This helps protect them from sudden financial strain.

3. High Yield Bonds Offer Attractive Returns

Income Potential That Beats Many Investments

Investing in high-yield bonds provides an income stream that few other assets can match. Historically, high-yield bonds with yields between 7% and 8% have delivered median returns of 7.4% over the following year. Positive returns occurred 88% of the time when yields were in this range.

Current yields sit within this “sweet spot,” making high-yield fixed-income investments particularly attractive. Investors seeking consistent income can benefit from locking in these elevated rates.

Potential for Capital Appreciation

Bond prices rise when interest rates fall, boosting total returns. Over the past two years, rising rates pushed bond prices down. If the Federal Reserve cuts rates, as expected, high-yield bond prices could rebound significantly.

4. Faster Recovery from Market Downturns

High Yield Bonds Bounce Back Quickly

Market downturns make investors cautious, but history shows that high-yield bonds recover fast. Since 2000, whenever high-yield markets dropped more than 5%, they rebounded within five months on average. Some recoveries happened in as little as two months.

After a downturn, high-yield markets tend to generate strong gains. The average return in the 12 months following a drawdown has been 22%. Sitting on the sidelines means missing these opportunities.

Consistent Performance Through Market Cycles

Even during the global financial crisis, high-yield bonds delivered steady long-term returns. Investors who bought in 2007 and held for five years earned an annualized return of 7.6%.

This pattern suggests that high-yield bond investing rewards patience. As long as investors focus on high-quality issuers, they can navigate downturns while earning attractive yields.

5. Diversification Benefits for an Equity Portfolio

Reducing Equity Market Volatility

Many investors ask what percentage of a portfolio should be in high-yield bonds. The answer depends on risk tolerance, but even a modest allocation can smooth out returns.

During stock market downturns, high-yield bonds tend to fall less than equities. Equities have historically taken longer to recover, while high-yield bonds bounce back faster. Allocating a portion of a portfolio to high-yield debt can help mitigate losses during market stress.

A Complement to Stocks for Higher Risk-Adjusted Returns

High-yield bonds do not always move in sync with equities, making them a valuable diversification tool. Even a small shift from equities into high-yield bonds can improve overall portfolio performance by balancing risk and return.

Investors who want exposure to the stock market without taking on excessive volatility should consider a carefully planned allocation to high-yield bonds.

Downsides of High Yield Bonds

While investing in high-yield bonds offers many benefits, it is important to understand the risks involved. Like any investment, high-yield bonds come with potential downsides that investors should consider before adding them to their portfolios.

Higher Risk of Default

High-yield bonds, also known as junk bonds, come with greater credit risk than investment-grade bonds. Companies issuing these bonds often have lower credit ratings, meaning they are more likely to face financial difficulties. If an issuer defaults, investors may lose part or all of their investment. Although default rates are expected to remain low in the near term, they can rise during economic downturns.

Greater Sensitivity to Market Conditions

High-yield bonds tend to be more volatile than other types of fixed-income investments. During periods of economic uncertainty, their prices can drop quickly, just like stocks. Investors who panic and sell during downturns may lock in losses instead of benefiting from the eventual recovery.

Interest Rate Risk

Like all bonds, high-yield bonds are affected by changes in interest rates. When interest rates rise, bond prices usually fall. While high-yield bonds are less sensitive to rate changes than investment-grade bonds, rising rates can still impact their value. However, investors who hold until maturity can still earn their expected income.

Liquidity Challenges

Some high-yield bonds may be harder to sell, especially during market stress. If too many investors try to sell at once, bond prices can drop sharply due to a lack of buyers. Investors should focus on bonds with strong liquidity to minimize this risk.

Lower Priority in Bankruptcy

If a company goes bankrupt, bondholders are paid before stockholders. However, unsecured high-yield bonds rank lower in priority than secured debt. This means investors may recover less money if an issuer defaults. Secured high-yield bonds offer better protection, so investors should consider them when managing risk.

Embrace High Yield Bonds with Caution

High-yield bond investing presents a compelling opportunity, even in the late stages of the credit cycle. With strong corporate fundamentals, extended maturity timelines, and attractive yields, these investments offer a unique balance of risk and reward.

However, high-yield bonds also come with risks, including default potential, market volatility, and liquidity challenges. While risks exist, history shows that high-yield bonds perform well in different market conditions. Allocating a portion of a portfolio to these bonds can enhance income, provide downside protection, and improve risk-adjusted returns. With careful selection and proper risk management, high-yield bonds can be a valuable addition to a well-diversified portfolio.