Credit | High yield: The return driver investors may overlook

Put simply, a certain gain can be more valuable than a larger but less certain one.

Medieval falconers may not have been building high-yield portfolios, but we believe the principle certainly still applies to bond investors today.

High-yield investing often draws attention to its potential to benefit from improving company fundamentals and tighter credit spreads – the extra yield a corporate bond offers above a comparable government bond. Yet, we believe one of the asset class’s most important return drivers receives far less attention: coupon income. That may be an oversight.

The overlooked source of return

High-yield total returns come from three main sources: coupon income, changes in credit spreads, and sometimes movements in government bond yields.

Credit spreads can be volatile, reflecting company-specific developments and broader shifts in market sentiment. Government bond yields have less influence on returns, except under extreme circumstances. Coupon income is different. It tends to be more predictable and continues to accumulate even when markets experience periods of volatility.

The importance of that distinction becomes clear when examining the historical drivers of high yield returns (Chart 1).

According to ICE data, coupon income generated 97% of total high-yield returns over a 10-year period and 104% over two decades. In other words, coupon income did much of the heavy lifting, helping offset periods when spreads widened or government bond yields moved against investors. The asset class's long-term return profile has been driven less by occasional market re-ratings and more by the steady accumulation of income.

That matters in today's environment. Investors remain focused on income, and understandably so. Equity valuations are elevated by historical standards, while cash and government bonds may not provide sufficient income for investors seeking returns beyond low single digits.

High yield offers an alternative source of income within an asset class that can contribute to total return.

Why more yield is not always better

However, recognizing the importance of coupon income is not the same as advocating a simple search for the highest yields.

In practice, that approach can lead investors into parts of the market where elevated yields reflect heightened default risk rather than mispriced opportunity. A high coupon can be attractive, but if capital losses or defaults follow, those benefits can quickly disappear.

The challenge is therefore not to maximize yield at any cost. It is to identify issuers that offer attractive income while maintaining a credit profile that appears stable or improving. Fundamental credit analysis remains central to that task.

The market's income sweet spot

Our investment process divides the investable universe into deciles – 10 equal groups – based on credit spreads. We then compare different parts of the market and assess where income opportunities appear most compelling relative to the risks being taken.

This exercise highlights an important feature of the market. At one end, sit bonds offering relatively little income, which can dilute portfolio yield. At the other sit bonds with the widest spreads, where investors may be taking on substantial credit risk.

Between those extremes lies a more attractive opportunity set. Our analysis suggests that deciles seven to nine may offer a meaningful yield advantage over the broader high-yield universe without necessarily forcing investors into the riskiest segment of the market (Chart 2).

These areas can provide access to attractive coupon income while limiting exposure to issuers where spreads may be signaling a materially higher probability of default. 

The goal is not simply to buy the highest-yielding bonds available. Rather, it is to identify companies where the income on offer appears attractive relative to the underlying credit risk.

That brings us back to the bird in the hand. The prospect of spread tightening can be appealing, but it remains uncertain. Coupon income is more tangible. While market cycles will continue to create winners and losers, the evidence suggests that coupon income has historically been the primary contributor to long-term, high yield returns.