The Federal Reserve Open Market Committee has advised us that extremely low interest rates will continue into 2015. For this reason, and investors’ obvious desire for yield, it is a good time to review the arguments regarding allocation to high yield bonds in balanced portfolios.

One thesis in favor of high yield bonds says they are “stocks with a lot of yield.” The chart here shows price performance of ETFs for high yield bonds (blue), stocks (green) and bonds (red). From the stock market lows in March of 2009, a visible correlation between high yield bonds and the S&P 500 exists. We believe there are several material differences between the high yield universe and the equity market. One is the inherent leverage on the balance sheets of the component companies. Another is the capacity for growth. The high yield universe is comprised of those companies whose fortunes have deteriorated (“fallen angels”), those restructured by private equity and those with highly leveraged balance sheets. These characteristics make the high yield universe more sensitive to credit market cycles with less margin of safety than that of the average large public company.

While the high yield market has the highest correlation to the equity market among bond market sectors, we do not believe the “stocks with yield” thesis holds up. We prefer to call them “bonds with the volatility of the stock market.” High yield bonds, like all bonds, mature at par value on a specific future date. The credit risk of the high yield market necessitates a widely diversified portfolio to minimize single-issue risk. Portfolio diversification of 100 equal weighted holdings is more essential for risk control than in any other bond market sector.

We characterize the objectives for the fixed-income portion of most balanced portfolios as “protect principal, generate income and offset volatility in other asset classes.” The long-term correlation between high yield and equity markets presents a decided conflict with the third component of those objectives. Asset allocation is the most appropriate place to make decisions regarding tolerance for volatility.

High yield can be more appropriately included if a portfolio’s objectives prioritize maximum income while absorbing increased volatility. We believe that any asset allocation decision should consider risk tolerances for volatility measured against income and liquidity needs. Investors should avoid the temptation to over-emphasize yield, particularly in an environment where yields are extremely low.

The options expressed in this article are those of Haverford. The S&P 500 index is a market capitalization weighted index of large cap stocks. It is not possible to invest directly in an index. Views and security holdings are subject to change at any time based on market and other conditions. This article is for informational purposes only and should not be construed as investment advice or recommendations with respect to the information presented. No forecasts are guaranteed and past performance is no guarantee of future results.