Who’s afraid of a big, bad junk bond? Not necessarily asset allocators, if our recent conversations with them serve as a good indication.

While high-yield bond funds might not be among the most popular fixed income options in our database, they have their fans despite the current macroeconomic environment – and high-yield bond funds have held up well.

Whether investors ultimately favour them over other types of fixed income assets – especially those in the investment-grade category – depends on the trajectory of the global economy.

“Should interest rate expectations fall and recession concerns rise, investment-grade bond funds are likely to outperform,” predicts Paul Angell, head of investment research at AJ Bell.

This is because interest rate risk is typically higher in the investment-grade world, given that high-quality companies can issue debt over longer periods of time.

In turn, the price of these funds fluctuates in line with central bank decisions. If and when interest rates start to come down, the income payments of existing bonds (ie those issued near the peak of the rate hiking cycle) will look more attractive.

Put bluntly, investment-grade assets shine the brightest when the economic forecast is gloomy. 

“If the economy remains stable, corporate defaults remain low, and interest rates hold, or even rise, then high-yield bond funds will almost certainly outperform,” Angell adds.

These assets are less influenced by the actions of central bank bosses Andrew Bailey and Jerome Powell because their constituents issue debt over a shorter term. Shifts in interest rates are therefore less likely to have an effect on the return profile of the related bonds.

The success of high-yield funds – and their appeal to allocators – is largely dependent upon the credit profiles of their constituent companies. These look slightly insecure by definition, given that credit rating agencies have judged them to be more likely to default than investment-grade peers.

Of course, investors willing to take this risk can be rewarded.

“The return of high-yield bonds tends to be around 3 per cent or so over and above treasuries or above the risk-free rate,” says Ahmer Tirmizi, head of fixed income strategy at 7IM.

“The challenge is that when you have particular periods of market stress, the bonds tend to sell off by more than they should do. Investors in this asset class tend to overreact, possibly because of the nature of the asset class.”

High-yield sell-offs have accompanied pretty much every economic calamity of the past few decades. We saw meltdowns when the dotcom bubble burst at the start of the century, and when the true scale of the subprime scandal came into view in 2008.

It has been noted that high-yield bond funds behaved much like equities did when Covid-19 struck – meaning that they crashed in a rapid and spectacular fashion. 

The global economy is still recovering from the latter shock as we speak. The pandemic, and the policy responses to it, were of course major contributors to the inflationary spiral.

What happens next will either strike fear into the hearts of junk bond investors, or fill them with confidence. High-yield assets can be high drama. 

Over the past three years, roughly since inflation started rising in the UK, the IA Sterling High Yield sector has romped home with an average return of, well, 4 per cent.

Meanwhile the IA Sterling Corporate Bond sector has lost nearly 8 per cent.

“If the world breaks out into a soft landing, and everything is going to be okay, then this is a fantastic asset class to hold,” says Tirmizi.

“If there is more volatility, you can still buy now and hold on – and that return will eventually come to you. Your risk tolerance determines whether you can weather this potential storm.”

Average allocations to investment grade and high yield have bobbed up and down in recent years but have broadly not changed much since 2022.

For its part, AJ Bell reduced its high-yield exposure recently following a period in which this had been the strongest-performing segment of its fixed income division. 

“At this point we feel that valuations have become tight in the market, particularly if developed market economies struggle under higher interest rates,” Angell explains.

“Whilst not enamoured by valuations within investment-grade credit, we do prefer it for its higher exposure to interest rate risk against a backdrop of cycle-high interest rates.”

According to John Husselbee, head of multi-asset at Liontrust, high-yield products have recently contributed to the positive performance of a number of its portfolios.

But like Angell at AJ Bell, he does not seem to think there is much room left to run, declaring his organisation “broadly neutral” on the asset class.

Iain Stealey, manager of the JPM Global Bond Opportunities fund and international chief investment officer for global fixed income, currency and commodities, said the lowest quality issuers had already been identified by the market and already trade at much wider spreads.

He said: "Stripping these issuers out, the rest of the market is structurally of a higher quality than in the past, with many of the lower-rated issuers having moved out to the loan market. On this basis, tighter spreads can be justified, and it could be a good opportunity to pick up some additional carry from high yield bonds – providing the soft landing narrative continues."

He pointed out that the macro environment was "fundamentally different" to early 2023 when inflation was rising and central banks were tightening, with many expecting interest rates to start falling in 2024.

Stealey said: "The biggest beneficiary of this environment is likely to be high-quality corporate bonds, which provide the defensive characteristics of core bonds with an extra pick- up in yield via a spread above the risk-free rate."

However, it is positive on the outlook for investment-grade bonds. 

“We believe there are opportunities because the spreads they offer over government bonds means our managers can find high-quality companies trading at attractive nominal yields,” he explains.

And returning to the performance of the respective sectors, perhaps there is some truth in that. Over the past three months the Sterling High Yield and Sterling Corporate Bond sectors have delivered virtually identical returns, suggesting investment grade might be catching up.

Jennifer Johnson is deputy funds editor on sister title Investors' Chronicle