High-Yield Bonds: An Antidote to Volatility?

As volatility roils the financial markets, investors may be eyeing risk assets with unease, including high-yield bonds. But our research suggests that high-yield bonds can serve as a surrogate to stocks, providing equity-like returns over varying market cycles, with a fraction of stocks’ volatility. We believe high-yield bonds, featuring elevated yields and attractive credit spreads, are especially compelling in today’s turbulent market.

The US economy is entering a period of slower growth, in our view, with tariffs threatening global trade and consumer price stability. In recent months, investors trying to unpack policy uncertainty have seen the animal spirits that ushered in the new year fade. But fixed-income investors have navigated uncertainty before. As long as capital isn’t permanently impaired, credit strategies have the potential to deliver strong long-term results—even when growth prospects dim.

Elevated Yields Bode Well for Future Returns

Let’s start with elevated yields. Yield to worst for high yield currently exceeds many 10-year equity return projections—good news not only for income-oriented investors but also for those seeking to maximize total return. Historically, yield to worst has been a reliable predictor of five-year forward returns, through good times and bad (Display).

Since the last major default wave in 2020, strong corporate balance sheets, coupled with fewer low-rated issues coming online, have helped stabilize high-yield credit quality. As a result, many high-yield issuers today are higher rated, with lower leverage, better cash flow and less cyclicality. Technicals are also supportive, with demand outpacing supply by a healthy margin and institutional investors stepping in to absorb recent retail outflows.

High Yield Helps Reduce Overall Portfolio Volatility

Equally encouraging is how high-yield bonds have performed during previous periods of equity volatility. High yield has historically experienced only half the volatility of stocks—and, more recently, only about one-fifth of stocks’ volatility (Display).

Furthermore, our research suggests that high yield has the potential to perform especially well when GDP growth is below trend (Display). As such, we think high yield could be a strong choice for investors looking to rebalance their recent overweights in equities and underweights in bonds.

High Yield Outperformed Equities as Spreads Widened

Credit spreads widened by roughly 60% in April as tariff news hit the markets. Even so, since mid-February, high-yield bonds have outperformed the broader equity market. We view this as evidence of the sector’s resilience—and a potential buying opportunity.

It’s true that spreads might widen further. But we don’t view this as a major concern. Today, the elevated yields of high-yield bonds—the result of both higher Treasury yields and wider credit spreads—provide ample cushioning against the negative price effect of further spread widening. Historically, credit markets have tended to rally after a significant equity correction, and when spreads are this wide, conditions would need to deteriorate quickly for high yield not to provide a competitive return.

Investors sometimes wait until spreads are even wider before taking action. That’s rarely the prudent choice, in our view. Not only is timing credit-spread movements virtually impossible, but investors miss out on high-income and return potential in the meantime.

Credit Selection Is Key to Dodging Defaults

A moderate level of tariffs is likely here to stay, which could lead to continued global trade frictions. How these tensions will ultimately play out is difficult to say. Using a conservative, probability-based framework, we believe high yield stands out as one of the best asset classes to navigate any number of growth scenarios.

In this precarious environment, industry and credit selection will be critical. While a default wave is possible, we don’t see that happening outside of the lowest-quality cohorts. We view CCC-rated issues as particularly risky, as they typically see the lion’s share of high-yield defaults. But even bonds rated higher than CCC—especially economically sensitive cyclical credits—can be risky if growth slows and market volatility escalates.

By contrast, high-quality, shorter-duration securities look compelling to us right now. Allocating to shorter-duration high yield exposes investors to less interest-rate risk while offering high levels of income and an attractive risk/reward profile in an increasingly uncertain environment.

Active Management Can Help Manage Risk

With market uncertainty likely to continue, we believe investors should look to active management to navigate today’s unique challenges. Through careful fundamental research, active managers can target sectors that are less susceptible to economic weakness while identifying mispricings.

The adverse effects of tariffs and deteriorating consumer sentiment warrant particularly close scrutiny. Some companies will struggle more than others in the new tariff environment, and with borrowing costs high and trade tensions mounting, the US economy can’t withstand shocks the way it once could. The Fed will have to weigh how much easing is possible if tariffs fuel inflationary pressures in a slower-growth environment.

But as we see it, it’s at times like these that high yield has the potential to outperform other asset classes. For investors looking to rebalance portfolios, we believe high-yield bonds may be a smart way to reduce overall portfolio risk—without sacrificing return potential.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

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