A Spectrum of Risk: Navigating High-Yield Bonds for Your Clients

In today’s investment landscape, high-yield bonds have grown into a component of many client portfolios. These instruments offer the potential for higher interest payments, which can boost regular income, and may also provide opportunities for capital gains, enhancing overall portfolio returns. Additionally, they can help diversify fixed-income strategies by offering exposure to different types of credit risk.

For today’s best financial advisors, mastering the art and science of high-yield analysis is not optional — it’s a requirement. Whether deepening your expertise or advising on these instruments for the first time, building nuanced insights into high-yield strategies is critical to gaining your clients' trust and staying ahead in a competitive advisory market.

High-yield bonds, once dismissed as speculative “junk,” has evolved into a mainstream fixture, with over $1.5 trillion circulating globally. Yet, this asset class presents a dual-edged opportunity. While they can enhance portfolio yield, high-yield bonds come with increased risk, requiring careful analysis and tailored advice. Advisors who go beyond traditional credit ratings — offering both context and value-added insights — will set themselves apart in an increasingly crowded field.

Why Ratings Alone Aren’t Enough: Enhancing Client Communication

Advisors seeking to deliver exceptional value cannot solely rely on credit ratings from Moody’s, Fitch, or S&P. While these agencies provide important baseline information, ratings are inherently backward-looking. They offer a snapshot of an issuing company’s creditworthiness but do not account for nuances like industry shifts, management changes, or short-term liquidity challenges — factors that may impact performance.

A truly skilled advisor goes deeper, providing forward-looking assessments and stress-testing scenarios to align recommendations with clients’ objectives and risk tolerance. Explaining the drivers behind bond pricing and yield spreads ensures that clients understand not only the potential return but also the downside risks — a vital part of maintaining trust that drives business growth through referrals.

A Multi-Layered Approach to High-Yield Bond Analysis

Developing a sophisticated view of high-yield bonds requires blending fundamental credit analysis with relative value analysis, alongside awareness of market trends, sentiment, and macroeconomic factors.

• Fundamental Credit Analysis: This approach assesses an issuer’s ability to meet its debt obligations by examining metrics such as debt-to-EBITDA, debt-to-equity ratios, and interest coverage ratios. However, clients need to understand that leverage ratios alone do not tell the whole story. Assessing covenants — including limitations on additional borrowing or dividend payouts — is crucial for evaluating the structural protections that safeguard bondholders.

• Relative Value Analysis: Here, advisors identify pricing inefficiencies by comparing yield spreads across bonds with similar ratings and maturities. A wider-than-expected spread might signal either an undervalued opportunity or hidden risks. For example, advisors can evaluate event risks, such as mergers and acquisitions or regulatory changes, that might disproportionately affect certain issuers within a sector.

By combining these techniques, advisors not only identify attractive opportunities but also forecast scenarios where specific risks may emerge — allowing them to adjust client allocations proactively.

Actively Managed Funds vs. ETFs: Finding the Right Vehicle for High-Yield Exposure

Advisors helping clients gain exposure to high-yield bonds must consider whether to recommend actively managed funds or passive funds, often offered as Exchanged Traded Funds (ETFs), with each having unique advantages.

• ETFs: High-yield ETFs offer liquidity and transparency, often tracking broad indexes that provide instant exposure to multiple sectors and issuers. They come with lower fees than most actively managed funds and can be an efficient tool for clients seeking diversified exposure at a lower cost. However, because ETFs generally follow a passive strategy, they may not actively adjust to credit risks or market changes as quickly as their active counterparts.

• Actively Managed Funds: Actively managed funds provide an opportunity for outperformance through security selection and dynamic adjustments. Experienced portfolio managers may exploit mispricings, credit upgrades, or event-driven opportunities like interest rates moves more effectively than an index-based ETF. These funds are well-suited for clients willing to pay higher management fees in exchange for personalized strategies aligned with shifting economic conditions.

Given the trade-offs, advisors should consider a blended approach, integrating both ETFs and actively managed funds to balance liquidity, cost, and flexibility. This allows clients to capture market beta through ETFs while pursuing alpha through active management.

Integrating High-Yield Bonds with Alternative Assets

For high-net-worth clients or those managing complex portfolios, high-yield bonds can also complement alternative asset strategies such as private credit, real estate investment trusts (REITs), or structured notes. When used thoughtfully, these instruments can further enhance portfolio returns and resilience.

• Barbell Strategies: Advisors can structure portfolios using a barbell strategy, balancing high-yield bonds on one end with investment-grade bonds or shorter-term bonds or cash equivalents on the other. This approach reduces overall volatility while maintaining higher income potential.

• Private Credit: High-yield bonds often share characteristics with private credit instruments, such as senior secured loans. By integrating both asset classes, advisors can access illiquidity premiums while diversifying sources of income.

• Structured Notes: For sophisticated clients, advisors can use structured notes with high-yield exposure to provide enhanced returns while tailoring risk characteristics through embedded options. This strategy can help protect against downside risk while offering exposure to equity-linked returns or callable bonds.

These alternative strategies work particularly well for income-seeking investors throughout the different phases of retirement who are concerned about equity market volatility. They can also help those needing to optimize a long-term, globally diversified portfolio that is expected to fund a goals-based return objective.

Navigating Market Trends: Resilience and Risk in the Decade Ahead

High-yield bonds will continue to capture attention, as investors search for greater amount of income per dollar invested — especially in an environment where traditional fixed-income assets may struggle to deliver competitive returns. Should interest rates stabilize at relatively moderate to low levels, equity-like returns with bond-like stability will remain appealing, particularly for those clients seeking income strategies without fully committing to equities.

However, advisors must caution clients against viewing high-yield bonds as a panacea. Liquidity risks could resurface during periods of market stress. Moreover, sector-specific downturns — especially in highly leveraged industries such as energy or consumer discretionary — can lead to sharp price declines. Advisors must balance client expectations by exploring how high-yield allocations interact with other parts of the portfolio under diverse economic scenarios.

The resilience of high-yield bonds, as seen during the Global Financial Crisis, the Dotcom Bubble, and COVID-19 downturns, reflects their ability to rebound in volatile markets. With continued improvements in market infrastructure and the growth of ETFs and actively managed bond funds, investors benefit from greater liquidity and transparency — making these bonds a potentially sustainable part of a wider range of client portfolios.

Are You Ready to Go Long on High-Yield Expertise?

As more clients express interest in objectives that benefit from high-yield opportunities, advisors must elevate their proficiency in this area. Whether recommending individual bonds, high-yield ETFs, or actively managed bond funds, staying abreast of credit trends, economic indicators, and bond market innovations will be critical. Integrating high-yield bonds with private credit or structured strategies can further enhance value for clients with more complex financial needs.

The Investments & Wealth Institute's CIMA® certification equips advisors with advanced skills in portfolio construction and fixed income analysis, enabling them to conduct comprehensive evaluations of high-yield bonds.

Remember, your role as an advisor isn’t simply to manage portfolios; it is to educate, inspire, and safeguard clients’ long-term financial promises. High-yield bonds are poised to remain a cornerstone of modern portfolios. Will your expertise match their potential?

On November 13, 2024, 12:30 - 1:30 PM EST, Investments & Wealth Institute is proud to present on online learning webinar titled, “Not All High Yield is Junk.” In this presentation, Carl Kaufman Co-President, Co-CEO and Chief Investment Officer for the Osterweis Strategic Income Fund, and his colleague, John Sheehan, CFA, Portfolio Manager, will challenge the conventional notion that investment-grade bonds are inherently “safe” while high-yield bonds are “risky.”

You are invited to explore the nuances of bond market ratings and learn how market inefficiencies can create opportunities to build high-yield portfolios with risk profiles akin to investment-grade bonds — and how both segments can be strategically utilized in client portfolios. Attending registrants will earn 1 CE credit hour for CIMA®, CPWA®, and RMA® certifications or 1 CFP® CE credit hour (pending as of 10/3/2024).