The S&P 500 Index hit an all-time high on April 23, thanks to improving investor optimism. But for some equity investors, market highs signal a good time to reduce downside risk.
There are additional reasons investors may want to trim their sails. We’re nearing the end of one of the longest credit cycles on record. And the US yield curve has flattened—historically a signal of slower growth or possibly a recession ahead. Market conditions are likely to get rough.
That’s why it’s time to remind investors that—while equities should continue to comprise a very large part of a portfolio—a complementary allocation to high yield can be healthy.
Want Lower Volatility? Consider High Yield
Investors can efficiently lower their overall risk while only modestly curbing potential returns by shifting a modest allocation away from US equities and into US high yield (Display).
How is this possible?
First, high-yield bonds provide investors with a consistent income stream that few other assets can match. This income—distributed semiannually as coupon payments—is constant. It gets paid in bull markets and bear markets alike. It’s the main reason high-yield investors have historically looked at starting yield as a remarkably reliable indicator of future returns over the next five years—no matter how volatile the environment. After accounting for maturities, tenders and callable bonds, the high-yield market typically returns anywhere from 18% to 22% of its value every year in cash.
Along with these payments, high-yield bonds also have a known terminal value that investors can count on. As long as the issuer doesn’t go bankrupt, investors get their money back when the bond matures. All this helps to offset stocks’ higher level of volatility—and provide better downside protection in bear markets.