High-Yield Bonds: 6 Questions Before Investing

Question: Should I have exposure to high-yield bonds in my portfolio? If so, how much?

Answer: Among the appealing aspects of high-yield bonds is that, as their name implies, they offer higher yields than higher-quality bonds. In addition, high-yield bonds tend to trade more with broad credit markets, or the economic outlook, or a particular company's outlook than they do with Treasuries, making them less sensitive to interest-rate rises. And after recent poor performance (the category is down around 2.4% for the trailing one-year period through Sept. 18), high-yield bonds are looking more attractive to some investors based on valuations.

But high-yield bonds also have their fair share of drawbacks, including a fairly high correlation with stocks. Here are some considerations to help you figure out if a high-yield allocation makes sense for your portfolio. And, if so, how much you should devote to the asset class.

1) What Are High-Yield Bonds? First, a quick primer: High-yield bonds are those with credit ratings of BB or lower, according to S&P's methodology, or those rated Ba or below by Moody's. Those ratings, considered "below investment-grade," reflect the higher risk of default due to issuers' heavy debt burdens and/or business risk. These types of bonds, which are sometimes referred to as "junk bonds," pay higher interest payments to entice investors to take on the additional risk.

2) Do I Already Have Direct Exposure to High Yield?

A good first step for investors considering adding high-yield exposure is to check their portfolio's existing allocations. As Morningstar director of personal finance Christine Benz pointed out in a recent article, many investors may already have some junk exposure in their portfolios, as most broadly diversified bond funds have some latitude to venture into bonds rated below investment-grade. The typical intermediate-term bond fund has about 7% of assets in bonds rated BB or below currently, and some intermediate-term funds carry substantially higher weightings than that. (For example, Gold-rated

Funds that land in the non-traditional- and multisector-bond categories usually have a significant percentage of assets dedicated to high-yield bonds, as can funds in Morningstar's various allocation categories--conservative, moderate, and aggressive allocation.

If you have a portfolio saved in Morningstar.com's

, you can get a general idea of how much exposure to below-investment-grade debt you already have. It's possible that you don't need to own a dedicated high-yield fund if you already have plenty of exposure in your portfolio. (

can show you the percentage of your bond exposure that is considered low quality or not classified--click on the Portfolio X-Ray tab, then click on X-Ray Details, then click the "Bond Style" tab all the way to the right.)

3) Is My Portfolio Already Correlated to High Yield? Even if you don't have direct exposure to high-yield bonds in your portfolio, prospective investors should note that high-yield bonds have high correlations with equities. In fact, during the past 10-year period, junk bonds have had a higher correlation with equities than they've had with higher-credit-quality bonds. The correlation between the Bank of America Merrill Lynch High Yield Master II Index and the Morningstar US Market Index (an equity index that represents 97% of the investable U.S. market) is 0.75 over 10 years. By contrast, the correlation between the Bank of America Merrill Lynch High Yield Master II Index and the Barclays U.S. Aggregate Bond Index (which excludes high-yield bonds) is 0.26 during the same period. (The correlation between the Morningstar US Market Index and the Aggregate Index is 0.05 during the same period.)

Over a five-year period, the correlation between high yield and U.S. equities is even higher at 0.79, while the correlation between high-credit-quality bonds and high-yield bonds is lower, at 0.18. The Aggregate Index's correlation with equities is negative (minus 0.19) over the five-year period.

4) Can I Stomach the Volatility? Although the high-yield bond market is less volatile than the U.S. stock market as measured by standard deviation of the aforementioned indexes--around half as high over five years (5.96 versus 12.27) and about two thirds as high over 10 years (10.42 versus 15.25), there is still plenty of potential for volatility. For instance, the average fund in the open-end high-yield Morningstar Category lost 26.41% in 2008, while the Morningstar US Market Index fell 37.03% the same year.

In addition, an investor needs to carefully weigh his or her risk tolerance here, especially with regard to credit risk. Commodity weakness, especially in the energy sector, which makes up 13% of the Bank of America Merrill Lynch High Yield Master II Index, has taken a toll on high yield. As Morningstar analyst Sumit Desai recently pointed out, many firms, especially exploration and production companies, borrowed heavily during the past five years based on the assumption that oil prices would remain high. But as the price of oil has fallen dramatically, we've only just begun to see the extent to which defaults will plague the sector. "For that reason," Desai said, "we think high-yield investors need to remain cautious when it comes to [the] troubled [energy] sector." (That said, the high-yield default rate overall is still at a fairly benign level, and Morningstar corporate bond strategist Dave Sekera expects it to remain so.)

For some investors, high-yield bonds, with their high correlation to equities and potential for volatility and default risk, are not attractive enough to warrant an allocation in a diversified portfolio. Indeed, in a paper published in December 2012, Vanguard concluded that a market-weighted allocation (currently less than 7% of the U.S. bond market) to high-yield bonds would not harm a traditional diversified portfolio, but neither would it significantly enhance it. And at higher allocations, according to the Vanguard study, the downside risks inherent in high-yield bonds have tended to outweigh the diversification benefits after accounting for liquidity and investability.

If you want your bond allocation to provide diversification from the equities in your portfolio and provide ballast during equity market sell-offs, higher-quality bonds might be a better fit for your portfolio.

Another concern is how high-yield bond funds will perform during rising-rate environments. Conventional wisdom suggests that high-yield bonds are driven more by defaults and corporate fundamentals and less by interest-rate movements. But as Desai points out, the Fed's recent zero-interest-rate policy has forced many bond investors to move further out on the risk spectrum, away from traditional interest-rate-sensitive bonds (such as Treasuries) and toward more credit-sensitive securities like high-yield bonds. For that reason, it's possible that high-yield bonds could sell off if and when rates rise. 5) What Size Allocation Makes Sense? Despite these considerations, many investors believe high yield could benefit a portfolio. And many have made the case recently, in the wake of the category's sagging performance and the falling prices of energy and commodities, that high yield has some upside potential. Not only that, but valuations for high-yield bonds now appear much more reasonable, creating a potentially attractive entry point for investors, said Desai. (The yield spread was 5.71% as of Thursday, Sept. 17, among the widest levels seen since 2012.)

But Desai says that it's important for investors to treat high yield as a long-term strategic investment within a portfolio rather than a vehicle for market-timing and trading. For some investors, Desai notes, when considering high yield, it may even be helpful to think outside of the 70/30 or 60/40 stock/bond portfolio-allocation model: There is a wide spectrum of risk and return opportunity among different asset classes, and the trailing 10-year risk/return for high-yield bonds has been better than that of the S&P 500. With high-yield bonds, an investor can get a decent return with high income and the ability to compound that income, but with lower volatility. Desai also recommends sticking to the higher-quality areas within the high-yield market. "Don't reach for yield; focus on higher quality--you get return and lower volatility and the compounding effect," he said.

Brian Huckstep, head of strategic asset allocation for Morningstar Investment Management's North America team, also believes that high yield can play a part in an investor's long-term asset allocation; in his opinion, high-yield bonds have a great combination of return, volatility, and correlation that can meaningfully improve Sharpe ratios of multiasset portfolios. "Our long-run high-yield allocations for U.S. investors often top out around 9%. Many peer asset-allocation teams go higher and many go lower. There are shorter-term market environments like today, where fear in the market can push prices down and widen high-yield credit spreads."

Ultimately, choosing to devote a percentage of your portfolio to high yield and deciding how large the allocation should be largely depend on your preferences, including risk tolerance, time horizon, and outlook for the asset class. High-yield bonds are excluded from the well-known investment-grade indexes, such as the Barclays U.S. Aggregate Bond Index, as well as from funds that track this index (for example,

The high-yield weightings of many target-date funds range widely. The Gold-rated T. Rowe Price Retirement series stakes about 17% of its bond weighting in high-yield bonds, but what that means in terms of the overall portfolio weighting changes over time. For

6) How Should I Invest in High Yield? Many people believe that due to the illiquidity and difficulty of researching high-yield bonds, as well as the diversification risks of holding individual bonds that could default, an individual investor would probably be better off investing in a mutual fund or ETF to get high-yield exposure.

In terms of active funds versus index funds, the oft-repeated wisdom is that the high-yield market is an area where active management can add value. Though exchange-traded funds offer low costs and greater liquidity, some investors fear that this "liquidity mismatch" introduces risk--in other words, the liquidity of high-yield bond ETF shares is greater than the liquidity of the underlying market. However, Morningstar director of global ETF research Ben Johnson believes that those fears are overblown and reflect a lack of understanding of how ETFs work. That said, Desai points out that the liquidity debate aside, one potential drawback to high-yield ETFs is that, by design, they will own the most-leveraged companies.

If you decide to add a dedicated high-yield fund, our Morningstar Medalists are a good place to start. There are currently

. In addition, there are two closed-end funds--

In addition, as Desai points out, investors may be wise to avoid bond-fund managers that have stretched for yield by investing in lower-quality bonds or those that have heavy exposure to the dicier parts of the energy sector. In this article, Desai recommends three Morningstar Medalists that focus on the higher-quality tiers of the market and have managed to sidestep the worst of the energy meltdown.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.