High-yield income strategy | Fidelity

Managing the risks of high-yield bonds
Of course as savvy investors know, no investment comes without some risk and high-yield bonds are no exception. The risk premiums on these bonds reflect the concern that these bonds’ issuers are more likely to default than issuers of government, agency, or investment-grade corporate bonds. That risk of default can also rise when the economy weakens and companies’ earnings may decline. However, that rising risk may be accompanied by rising risk premiums and widening spreads between high-yield and Treasurys. That means that while the risk of an issuer defaulting may rise, the wider spread may compensate investors for that increased risk.
Chang points out that the risk of default may be somewhat lower today than it has been historically. “Over the last 10 years, roughly 50% of all newly issued high-yield bonds have been BB rated. This has led to a shift in the overall credit mix of the index relative to history. The percentage of BB-rated bonds within the index has increased from 45% in 2014 to 53% in 2024. Given the higher credit quality, investors could see a more benign default environment than they have historically,” he says.
Notkin manages default risk through careful research that seeks to avoid the riskiest issuers. “It’s not simply avoiding bonds with triple-C credit ratings and buying anything with a single-B rating,” he says. “It’s digging into the issuers’ circumstances and being able to price risk. Pricing risk in high-yield is more art than science. I don’t mean that it’s creative, but that it’s hard. The trick is to avoid the losers. I ask ‘Is this company stable?’ We want companies with good management and good return on capital. They are not typically the best of best but they’re not bad businesses. In some cases, there are really great businesses. Tesla and Netflix both got their starts in the high-yield market, and they’ve been incredible companies. We look for companies that are able to comfortably pay their coupons and where we’re comfortable with the capital structure. We’ve not gotten it perfect all the time, but we’ve picked companies that were able to pay their coupons and we’ve outperformed very nicely over time.”
Besides having higher risk of default than investment-grade bonds, high-yield bonds also differ from higher-rated bonds in that they tend to move more in tandem with stocks than with investment-grade bonds. Historically, that has meant that high yield has tended to underperform when the economy heads into recession and stocks fall. For that reason, most investors may also want to allocate a portion of their portfolio to investment-grade bonds, which historically have outperformed stocks and high-yield bonds during recessions.
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