Can a High-Yield Allocation Still Offset Equity Volatility?

Should you be concerned that high-yield bonds didn’t predict last year’s equity market selloff? We don’t think so. In fact, we think investors should consider adding high-yield exposure to reduce overall risk.

High-yield bonds have traditionally been a reliable early indicator of market trouble. Over the past 20 years, high-yield credit spreads—the extra yield investors earn for holding these assets instead of safer government debt—widened before every big equity market selloff, including the 1998 Russian default, the bursting of the bubble and the global financial crisis.

But some are wondering whether that streak ended last year when spreads narrowed in the months leading up to the S&P 500’s 7% October swoon—its worst monthly performance in more than seven years. The Wall Street Journalwent so far as to suggest that investors’ favorite stock market crystal ball may have finally cracked. As a result, investors are worried about complacency in the high-yield market and questioning the historically tight correlation between high-yield bonds and stocks.

Want Lower Volatility? Consider High Yield.

The way we see it, this is no reason to rethink the relationship between high yield and stocks—or the logic behind using high yield to de-risk an equity allocation.

To start with, it’s hard to say that high-yield investors are asleep at the wheel. After bottoming at 303 basis points on October 3, spreads widened by more than 200 basis points over the next three months. Yes, the high-yield market was a bit slower to react this time. But that doesn’t make it less relevant as a risk signal.

As some of the market participants quoted in the Journal story noted, there are plausible reasons for the lag, including the fact that companies issued fewer bonds in 2018 despite high demand from investors. The result: a supply-demand mismatch that propped up valuations and caused spreads to narrow.

We think high yield may have been slower to react because the equity selloff, while abrupt and disorienting, looked more like a correction than the start of a prolonged bear market.

That could change, of course. We’re nearing the end of one of the longest credit cycles on record and the US yield curve has been getting flatter—historically a signal of slower growth or possibly a recession ahead.

That’s why it’s a good time to remind investors that combining stocks and high yield can reduce overall risk when market conditions get rough without sacrificing much return (Display 1).