Here’s my take: I believe high yield bonds are close to fair value, I hold a neutral view of the asset class and I advocate that investors generally maintain a benchmark weight.
That said, in the following three instances, I’d advocate investors consider being more aggressive buyers of high yield:
1.) If spreads widen. The spread between high yield bonds and the 10-year Treasury has generally fluctuated between 500 to 600 basis points this year, about where high yield should trade given the sluggish economic environment. However, assuming no further deceleration in the US economy, any further widening of high yield spreads back toward a premium of 650 to 700 basis points over the 10-year Treasury would represent a good buying opportunity, especially considering that many corporate balance sheets generally have been extremely strong and default rates have been low.
2.) If they have portfolios with high income needs. With a yield to maturity a little under 7% and volatility of less than 10%, a fund like the iShares iBoxx $ High Yield Corporate Bond Fund, (NYSEARCA:HYG) is an efficient way to add incremental yield to a portfolio. As such, investors may want to consider adding high yield bonds to their fixed income portfolios as their demand for income rises. For instance, while risk adverse investors may only want to hold around 10% of their fixed income portfolios in high yield, investors willing to take incremental risk to earn additional income may want to consider holding as much as 30% of their fixed income portfolio in high yield.
3.) If they are worried about rising rates. Investors who are worried about rising interest rates may also want to add high yield as a substitute for long-dated Treasuries. High yield bond funds currently have lower durations than Treasury funds, meaning that Treasuries are far more sensitive to interest rates. If interest rates rise even modestly, Treasury funds are likely to suffer larger losses than high yield bond funds.