Investors often say they’re worried about having too much high-yield bond exposure so late in the credit cycle. But many are still chasing returns in equities and other assets with even higher risk. We’ve got a better idea.
Don’t get us wrong. We recognize how tough it is to generate income in today’s low-yield environment. But as we’ve pointed out before, the best way to boost income potential at this stage in the cycle without also boosting drawdown risk is to have a diversified high-income strategy that embraces multiple sectors and regions.
Today, we fear that too many investors are moving in the opposite direction, taking highly concentrated positions in high-risk assets and sectors in hopes of generating higher returns. Through April 30, investors poured $57.2 million into offshore open-ended mutual and exchange-traded funds that invest in equities, according to Morningstar. But they yanked $14.1 million out of global high-yield funds.
Some investors may not realize that overconcentrating in one asset or sector can expose them to higher-than-expected levels of volatility. The higher the level of volatility, the less predictable return streams are. This means investors may have to rely on larger upswings to make up for losses when they occur.
High-yield bonds and equities are both strongly linked to the business results and fundamentals of the companies they represent, making them both highly correlated with economic growth and the credit cycle. But investors who think they’re de-risking their portfolios by reducing exposure to the former while maintaining it to the latter may be disappointed.
Why? Because high-yield bonds have historically had lower volatility, even during some of the more tumultuous periods for capital markets. And over the long term, high yield has produced equity-like returns with about half the risk of equities (Display).
Looking for Yield in All the Right Places
Both high-yield bonds and equities deserve a place in any well-diversified portfolio. But the way we see it, it makes more sense to embrace a global, multi-sector strategy than to overconcentrate in either one. This approach offers a more predictable stream of income while diversifying sources of high income and risk when compared with strategies that take concentrated and single-sector bets in pursuit of higher yield.
Moreover, having a wide range of income generators is important because different sectors outperform at different times (Display).
Today, we see attractive opportunities in many US securitized assets, including credit risk–transfer securities, a new type of floating-rate mortgage-backed bond issued by the US government–sponsored housing agencies that should benefit when short-term rates increase.
Select emerging-market (EM) bonds look attractive, too, in large part because more governments have reined in their deficits and embraced tighter fiscal policies and good governance. In particular, we see value in certain local-currency-denominated securities, which offer higher real yields and help diversify exposure to US dollar–denominated bonds.
Again, though, overconcentration in just a few EM countries or sectors—some of which offer very high yields—is risky. That’s why it’s so important to be selective and diversified.
Don’t Abandon High-Yield Bonds
Picking your spots in high yield is just as important. But continued global growth suggests there’s still plenty of value to be had in this market. We see opportunities in the energy sector, where many issuers reduced leverage following the sharp decline in commodity prices in 2014 and 2015. And because the energy sector’s reputation has been damaged by the recent sell-off, energy bond valuations have not yet recovered.
We also see value in pockets of the banking sector—especially European banks that are earlier in the credit cycle than US industrial companies. These banks have solid balance sheets and continue to improve their capital ratios.
A Steady Hand on the Wheel
One more thing: weaving together an effective multi-sector high-income strategy is a complex undertaking that requires a thorough understanding of how different investments can impact risk and returns in different market environments. That’s why it’s important that investors or their managers know how to navigate opportunities as they arise throughout the market cycle.
Today’s market environment calls for caution in all types of investment strategies, high-yield bonds included. But reducing high-yield exposure while maintaining concentrated risky exposure elsewhere isn’t the right solution. We think a more diversified strategy is the best bet for maintaining income and reducing drawdown risk.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.