High-Yield Bonds in a Rising Rate Environment: Balancing Income and Risk

In the current rising interest rate environment, high-yield bonds present a compelling yet nuanced opportunity for income-focused investors. While these bonds have historically demonstrated resilience during periods of monetary tightening, their performance is inextricably tied to macroeconomic conditions, credit fundamentals, and investor sentiment. This analysis evaluates the potential of high-yield bonds in 2024–2025, focusing on income stability and risk-adjusted returns, while drawing on historical precedents and recent market dynamics.

Historical Resilience and Volatility

High-yield bonds have historically outperformed investment-grade bonds during rising rate environments when default rates remain low. For instance, in 1987, high-yield bonds returned 4.47%, outpacing investment-grade bonds' 1.84%, according to The Balance. Similarly, the 1991 recovery saw high-yield bonds surge 39.17%, compared to the S&P 500's 30.23%. These periods highlight the asset class's ability to deliver competitive returns, driven by shorter durations that mitigate interest rate sensitivity. However, the 2008 financial crisis starkly exposed their vulnerabilities: high-yield bonds plummeted -26.39% as defaults spiked and economic distress spread. This duality-strong performance in stable conditions versus acute volatility during downturns-underscores the need for careful risk management.

Current Market Dynamics: 2024–2025 Outlook

Recent data suggests a cautiously optimistic outlook for high-yield bonds. As of late 2024, U.S. high-yield bonds offered a yield-to-worst (YTW) of 7.5%, significantly higher than the 5.33% for investment-grade bonds, according to Morgan Stanley. This premium reflects both the elevated risk of high-yield credits and the market's demand for income in a low-yield environment. Projections for 2025 indicate moderate default rates: UBS Global forecasts a 4.8% default rate for USD high yield, though this drops to 3.1% when excluding two large distressed names. Northern Trust Asset Management further notes that default rates are expected to remain below the 4% historical average, supported by strong balance sheets and favorable economic conditions.

Credit spreads, a key indicator of risk compensation, have tightened to historically low levels. The ICE BofA High Yield index spread stands at 268 basis points, close to tights, according to Guggenheim Investments. While this reflects improved credit quality-evidenced by a higher proportion of BB-rated bonds and fewer CCC-rated issuers-the market remains vulnerable to widening if economic conditions deteriorate. For example, in Q3 2025, high-yield spreads widened to 445 basis points amid fears of a U.S. tariff war, marking the widest levels since November 2023, according to Reuters. Such volatility underscores the importance of active management and diversification.

Risk-Adjusted Returns: A Mixed Picture

On a risk-adjusted basis, high-yield bonds have historically underperformed investment-grade bonds since 2000, despite their higher raw returns, according to UBS Global. This is due to their greater volatility during credit market stress, such as the 2008–2009 Global Financial Crisis or the 2020 pandemic. However, structural improvements in the high-yield market-such as reduced exposure to CCC-rated issuers and stronger interest coverage ratios-have enhanced resilience, a point also highlighted by Guggenheim Investments. For 2025, UBS and AXA IM project total returns of 6–8% for USD high yield, with Asia ex-Japan high yield offering the highest potential at 7–12%. These forecasts assume a stable macroeconomic backdrop and controlled spread widening, though risks persist from inflationary pressures and geopolitical tensions.

Income Stability: Yields vs. Default Risks

The allure of high-yield bonds lies in their income generation. With current YTW at 7.5%, they remain a critical tool for income seekers. However, this yield comes with trade-offs. For example, during the 2022–2023 rate hikes, high-yield bonds returned -2.27% in 2022, reflecting the dual pressures of rising rates and economic uncertainty, according to CNBC. While shorter durations help cushion price declines, the asset class's sensitivity to defaults and liquidity shocks cannot be ignored. UBS's 2025 default projections, while modest, highlight regional disparities: Asia ex-Japan high yield faces a 5.7% default rate, driven by Chinese real estate challenges, compared to 3.3% for EUR high yield. Investors must weigh these regional nuances against their risk tolerance.

Conclusion: A Strategic Allocation

High-yield bonds offer a unique blend of income potential and diversification benefits in a rising rate environment. Their historical performance during favorable economic cycles, coupled with current tight spreads and elevated yields, makes them an attractive asset class. However, the risks-particularly during periods of acute stress-demand disciplined portfolio construction. A strategic allocation to high-yield bonds, paired with active monitoring of credit fundamentals and macroeconomic signals, can enhance risk-adjusted returns while preserving income stability. As the 2024–2025 outlook unfolds, investors should remain agile, leveraging the sector's strengths while mitigating its inherent vulnerabilities.