Updated October, 2014

High yield bonds have amply rewarded investors since the asset class first emerged in the early 1980s. High yield has topped all other bond market categories in the trailing five- and ten-year periods, and it has produced double-digit gains in 17 of the past 34 years. Not least, it has produced outstanding returns in relation to the underlying risk, giving it superior risk-adjusted returns versus both stocks and other segments of the bond market.

However, just because an asset category has strong past performance doesn’t mean that it will necessarily continue to outperform in the future. This appears to be the case for high yield at this stage, and investors need to temper their expectations accordingly. There are three reasons why the future performance of high yield bonds is likely to be lower than its past results:

The Bond Bull Market is Over: It’s important to keep in mind that the strength in high yield bonds has come in the context of a 31-year bond bull market. U.S. Treasury yields peaked and began to fall in 1981, near the time the high-yield market was beginning to emerge, and continued to fall until mid-2012. (Keep in mind, prices and yields move in opposite directions).

While high yield bonds are among the bond market segments least sensitive to interest-rate movements, the strength in Treasuries nonetheless has provided a tailwind for the high yield market throughout its history. Now that the bull market has run its course, this positive underpinning is no longer present.

If yields gradually rise in the coming years, as most experts anticipate, high yield bonds will be hard-pressed to repeat their past results.

Lower Yields: It’s also important to keep in mind the role of yield in high yield bonds’ historical total returns. This graph, from the Federal Reserve Bank of St. Louis, shows the absolute yields for high yield bonds over time. A quick look will show that high yield bonds have yielded as much as 22% and have spent a good portion of their history with yields north of 10%. Today, their yields are closer to 5% - far less than the previous lows of 2004 to 2006, when yields were in the 7.5% to 8% range.

This has enormous implications for future total return potential. An asset class that is yielding 10%, for example, has a five percentage-point head start over one that is yielding 5%. This yield advantage was part of the reason why high yield was able to deliver the following returns from 1982 through 1986: 32%, 22%, 9%, 26%, and 17%. High yield also produced gains of 43%, 18%, and 18% in 1991-1993. When high yield bonds offered yields north of 10%, it didn’t take much in the way of price appreciation to achieve a gain of 18%. Today, it would take much more in the way of price gains to reach a similar total return. Which brings us to the next point:

Low Yield Spreads Cap the Upside: If high yield bonds still had a large yield advantage over Treasuries, there would be plenty of potential for upside from price appreciation. As it is, the yield spread is near all-time lows (view the chart here). This means that in addition to losing yield as an engine of total return, there is also very little room for prices to rise. Further, prices are already so high that many bonds can’t rise further without being called away by the issuers.

Put it together, and the combination of low yields and low potential for price gains points to an era of lower future returns. High yield bonds have enjoyed outstanding results over time, but the asset class is now mature and no longer as inefficient as it was in the days when double-digit annual returns were commonplace. Make sure to temper your expectations, and be very wary of the potential risks.