The era of low yields and the investment challenges they bring isn’t likely to end soon. Ongoing geopolitical tensions and slowing global growth will contribute to persistently low and negative yields in 2020. A global slowdown could leave the world even more vulnerable to adverse shocks, leading to further bouts of volatility.
Fixed-income investors seem caught between a rock and a hard place.
Government bonds offer some downside protection, but with global yields near record lows, the protection feels thin, and the income stream may be inadequate.
On the flip side, higher-yielding credits can boost income but are also more volatile, especially when credit spreads are below historical norms, as they are today. That doesn’t appeal when credit cycles are long in the tooth.
Can investors can find a happy middle ground?
The Whole Is Greater than the Sum
When it comes to income-oriented investing, we’ve long advocated a single dynamic strategy that pairs return-seeking credit assets—high-yield corporate bonds, emerging-market debt and so on—with high-quality government bonds.
Such an approach has historically been a good way to generate income while limiting drawdowns, making it particularly valuable late in the credit cycle. This is mainly because the return streams tend to be negatively correlated. One does well when the other struggles, and a manager can alter the weightings as valuations and conditions change.
This effectively allows the investor to reduce volatility without giving up too much return. To see what we mean, let’s look at a couple of potential strategies.
The first is a portfolio with 65% of its assets in US Treasuries and 35% in high yield. We consider this a risk-weighted strategy because credit is typically twice as volatile as interest-rate-sensitive assets. Investors would have to hold more rate exposure to even out the risk weighting on each side.
The second is a 50/50 construction that excludes CCC-rated junk bonds—the riskiest slice of the high-yield universe. We call this a risk-managed portfolio.
Over the past 15 years, both strategies would have comfortably outperformed US Treasuries and provided 75% to 80% of the annualized return of US high yield. But as Display 1 shows, both would have had better returns per unit of risk than either US Treasuries or high yield.
Tilt Toward Government Bonds
As credit cycles wind down or geopolitical risks rise, a manager can rebalance investors’ portfolios by tilting toward higher-quality, interest-rate-sensitive securities at the expense of the riskiest sectors of the credit market. This makes a portfolio more liquid. Should credit markets sell off, investors can sell their outperforming US Treasuries and other highly liquid assets and rebalance toward higher-risk assets at more attractive prices.
To our mind, it makes sense today to tilt toward higher-quality securities. While we don’t expect a US recession, we are keeping an eye on the manufacturing slowdown and cooling world GDP growth. In addition, the US credit cycle is now in its eleventh year. That’s why, even though investors may be unhappy with low yields on government bonds, it would be a mistake to eliminate them.
It’s important to hold duration, or sensitivity to changes in interest-rate levels, when there’s significant uncertainty on the global geopolitical stage. During periods of market turbulence, government bonds’ duration serves as an offset to equity and credit market volatility, mitigating downside risk.
However, when the US Treasury yield curve is flatter than normal, as it is today, we think it makes sense to reduce holdings of long-duration bonds such as 20- and 30-year US Treasuries. These securities’ yield per unit of duration is low compared to the yield per unit of duration in the intermediate portion of the yield curve. Investors should therefore consider concentrating US Treasury exposure in bonds maturing in six to nine years.
Another reason to tilt portfolios toward rate-sensitive assets? Investors aren’t being properly paid to take credit risk. Most credit assets are expensive today. Take the US high-yield market, where the average extra yield (spread) over comparable government bonds averaged 3.4% on December 31, 2019. That’s well below the long-run average of 5.5% since January 1, 1994.
Of course, investors shouldn’t hold only government bonds. They should blend exposure to high-yield corporate bonds with positions in credits that offer an attractive mix of yield and quality, such as subordinated European bank debt and select investment-grade corporate and emerging-market debt.
Subordinated European bank debt was issued to comply with global Basel III regulations that required banks to build up equity capital buffers. Because they’re lower in the capital structure, subordinated bonds issued by investment-grade banks offer yields like those of speculative-grade securities.
In fact, yields on European additional Tier 1 (AT1) bonds, the securities that would take a hit first if the issuing bank ran into trouble, comfortably outstrip those on European and US high-yield bonds. European bank debt is particularly attractive because European financials are in a slightly earlier stage of the credit cycle than their US counterparts.
What other credits look attractive in the later stage of the credit cycle? Perhaps surprisingly, BBB corporate bonds, which offer yields like those in the high-yield market thanks to overblown fears about “fallen angels.” Many of these companies have prioritized debt reduction and still have healthy earnings.
Lastly, among traditional high-income-generating sectors, the dovish tilt by developed-market central banks is broadly supportive of emerging-market debt. The economic fundamentals of emerging-market countries have also markedly improved in recent years. We think these assets may get an added boost as monetary policy around the world gets even easier in 2020.
Think Outside the Box
But investors can do even more to reduce volatility sparked by geopolitical risk by adding securitized assets to their balanced strategies.
Why? Because US mortgage-backed securities are more resilient than high-yield credit to geopolitical risk.
Consider the higher-yielding assets on the return-seeking side of the mortgage strategy, such as commercial mortgage-backed securities (CMBS) and credit risk–transfer (CRT) securities—a kind of bundled residential mortgage debt issued by US government-sponsored enterprises Fannie Mae and Freddie Mac. As Display 2 shows, both CMBS and CRTs have weathered the ups and downs of the US-China trade war better than high-yield credit.
We think complementary allocations to credit and mortgage sectors may help smooth the returns of the overall mix over the long term, as the two have tended to outperform at different times. Securitized assets also have low correlations with other fixed-income sectors—including government debt—and asset classes. This makes them a powerful portfolio diversifier.
Here’s another reason to consider adding US residential mortgage exposure: home affordability has improved in most regions, and lower interest rates should bring down mortgage rates. Also, a strong US labor market means most borrowers can make their mortgage payments.
As a result, we still see opportunity in CRTs. These assets pool thousands of residential mortgages into single securities that provide investors with regular payments based on the underlying loans’ performance. Unlike typical agency bonds, CRTs don’t carry a government guarantee, so investors may absorb losses if large numbers of loans default. Even so, high borrower credit quality makes CRTs attractive; many have been upgraded to investment-grade status.
CMBS can also boost portfolio income, as they offer a healthy yield pickup over corporate bonds. The sector has been out of favor in recent years, in part due to fears around a retail apocalypse—concerns that our research indicates are exaggerated.
Finding Higher Ground
Income-oriented bond investors will need to navigate a narrow path through 2020. That means finding a way to keep the income flowing while also shielding the portfolio from the full effect of higher volatility and slower growth. With the right mix of credit, government bonds and securitized assets, we think investors will find that higher ground.
Matt Sheridan is Portfolio Manager—Global Multi-Sector at AB.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams, and are subject to revision over time.