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By Rob Hannon
Core bonds have long served as the centerpiece of investors’ fixed income portfolios because they have historically provided a combination of diversification, yield and stability. Yet since the 2008-2009 financial crisis, U.S. interest rates have remained relatively low, leaving investors to search for income outside their core bond portfolios.
Some investors have turned to dividend-oriented equities to augment their income. However, heightened stock market volatility and the aging bull market may be reasons to seek additional income sources.
High-yield bonds offer another option for investors looking for income to complement–not replace–their core bond portfolios. While high-yield bonds are more volatile than core bonds, the additional risk comes with greater income potential than either core bonds or dividend-oriented equities.
Credit risk–or the risk an issuer will default on its obligations–represents the primary risk for high-yield bonds. Default risk can vary considerably within the category, as individual high-yield bonds carry ratings from BB (highest quality high yield) to D (lowest quality). Yet even within each rating category, business and financial risk can vary widely across companies.
In addition, the performance of high-yield bonds is subject to a wide variety of economic and market influences. For example, performance can vary depending on whether credit spreads – the difference in interest rates between highly rated U.S. Treasury bonds and lower-quality high-yield bonds with similar maturities – are wide or narrow.
FROM A RISK/REWARD PERSPECTIVE, HIGH-YIELD BONDS RESIDE BETWEEN CORE BONDS AND EQUITIES
By choosing a passive high-yield strategy that mirrors an index, an investor could unknowingly invest in the debt of companies with high levels of business and financial risk. That’s why we believe investors may benefit from the expertise of an active manager who seeks to identify the most attractive bonds within the high-yield category and navigate the various risks.
A skilled active manager can look for companies with the potential to carry their debt loads through changing market and economic conditions and reduce debt over time. In-depth, company-specific research can identify companies with specific attributes, such as well-positioned product lines, experienced management teams, and the ability to deliver attractive cash flows.
The high-yield landscape can shift quickly as economic and market conditions change. When this occurs, index-based passive investment strategies don’t have the flexibility to trade higher-risk debt for more attractive opportunities. This characteristic of passive investing potentially exposes investors to substantial losses in their portfolios. By contrast, active managers can respond to changing market conditions, which may help shield investors from some of the declines in the high-yield market.
An actively managed portfolio of high-yield bonds may effectively serve as a complement to core bonds for investors who understand the risks. Used judiciously, high-yield bonds may enhance the income, total return potential and diversification of a portfolio.
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Diversification does not assure a profit nor does it protect against loss of principal.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.