By Amey Stone

High-yield bonds appear to be overvalued right now, but that doesn't mean investors should avoid them.

For years, the knock against high yield has been that it doesn't yield enough to compensate investors for the risk they are taking by investing in junk bonds. Currently, the index-tracking SPDR Bloomberg High Yield Bond exchange-traded fund (ticker: JNK) yields 6.94%, 2.3 percentage points more than the benchmark-tracking iShares Core U.S. Aggregate Bond ETF $(AGG.NZ)$, which yields 4.6%. Veteran analyst Marty Fridson, CEO of FridsonVision High Yield Strategy, views high yield as "severely overvalued," as it has been several times since 2023.

Yet high-yield bonds in general have delivered excellent results for the past two years. The SDPR ETF returned 13.2% in 2023 and 7.4% in 2024. "I have been waiting for a credit event for two years now and have been wrong," says Richard Daskin, president of RSD Advisors.

Clearly, the sector has other things going for it. Principal among them is the yield -- about 7%, when the average money-market fund yields 4.2%. That can provide a cushion for returns if spreads, the yield difference between high-yield and Treasury bonds, widen modestly, says Fridson.

Plus, the asset class is less vulnerable to falling interest rates than investment-grade bonds. High yield carries nearly half the duration risk, a measure of how much a bondholder could lose if rates rise, than core bonds, says John McClain, manager of the Brandywine Global High Yield fund (BGHAX), which has returned an average 6% a year for the past five years, putting it in the top 2% of the category. The iShares AGG ETF has lost a painful 0.6% a year for the past five years.

Yes, junk adds more credit risk to a bond portfolio -- and shouldn't be more than about a 15% allocation -- but it can also reduce risk compared with equities. The quality of high yield is generally higher now than in the past, McClain says. Double-B bonds, a high tier of below-investment-grade, are now 54% of the market versus 38% in the early 2000s.

One reason spreads have tightened is because there are fewer high-yield bonds available, as junk-rated companies have turned to private lenders and loan markets for financing. "There has been limited net supply in the asset class for a long time now," says McClain. "That has provided a strong tailwind."

Some of the biggest risks looming for stocks this year are muted for high-yield bonds. "Tariffs will have a much more limited impact on the high-yield asset class," says McClain, since most high-yield-issuing companies concentrate their sales in the U.S. And risks from higher inflation, which could be fueled by policies such as deportations, are generally lower. For highly indebted companies, inflation can be helpful, since debts become easier to pay back as prices rise. "There will be sectors that will be negatively impacted, but generally our asset class is a good place to wait out market volatility," he says.

Active management can be a plus for this sector, says Michael Arone, chief investment strategist of State Street's SPDR ETF business. He is a fan of the SPDR Blackstone High Income ETF $(HYBL)$, which yields 6.9% and incorporates leveraged loans and collateralized mortgage obligations in addition to high yield. It has returned an annual average of 5.6% for the past three years.

In general, bond experts argue it's best to stay in the higher-rated parts of the junk bond market. RSD's Daskin still believes credit will eventually get hit along with stocks by Trump policy changes, but how much will vary depending on the company and industry. "The best clue for how high-yield credits will hold up," he says, "is how the stock market is doing."

Write to Amey Stone at amey.stone@barrons.com

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February 21, 2025 21:30 ET (02:30 GMT)

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