High-Yield Bonds: Higher Income Potential, But Default Risk is Elevated

Key Points

  • High-yield bonds offer some of the highest yields and income potential of all fixed income investments.
  • High-yield defaults are occurring at the fastest pace since 2009, and we believe the trend will continue.
  • We suggest investors focus on “higher-rated” high-yield bonds, and limiting exposure to bonds rated “CCC,” as they are the most likely to default.

With average yields close to 6%, high-yield bonds can offer investors an opportunity to earn more income in a very low-interest-rate world. That’s a benefit not many fixed income investments can provide.

Those higher yields come with greater risks, however, and despite the strong performance recently, we believe investors should approach the market carefully because risks remain elevated. High-yield corporate bonds are defaulting at the fastest pace since the 2008-2009 financial crisis, and we expect the number of defaults to continue to climb. While the economic rebound from the lows earlier this year is a positive, many high-yield issuers were already struggling before the pandemic hit.

Meanwhile, support from the Federal Reserve is primarily focused on investment-grade corporate bonds, not high-yield corporate bonds. If the economic outlook were to deteriorate or the stock market were to fall further, it could be a bumpy ride for high-yield bonds.

Despite those risks, investors can still consider high-yield bonds as a complement to a well-diversified bond portfolio, but we do not suggest an overweight allocation. We suggest investors limit any high-yield allocation to no more than 20% of the overall portfolio. Those interested in high-yield corporate bonds should consider an “up-in-quality” tilt, focusing on bonds (or funds that hold bonds) whose ratings are in the upper rungs of the high-yield universe, like those rated “BB.”