Late-cycle markets can unnerve high-income investors. But we see ways to generate a healthy level of income while potentially decreasing overall risk.
When markets are in the later stages of the credit cycle and systemic risks are heightened, investors often do one of the following:
- Some react to slowing growth and low or negative interest rates by stretching for more yield in CCC-rated corporate bonds or other higher-risk, lower-quality assets. And they often do it by investing in concentrated, single-sector strategies that lack diversification.
- Others shy away from return-seeking credit assets altogether, accepting less income in exchange for better protection against large drawdowns.
To our minds, neither approach stands much chance of helping investors reach their goals. The first approach exposes them to too much risk—likely with inadequate compensation—while the second limits income potential and may not provide as much protection as investors expect.
Instead, investors should consider globalizing their high-income strategies and looking for opportunities across fixed-income sectors. This diversifies a portfolio, increasing income potential and reducing downside risk. Both are important because the risk associated with “risk assets”—high-yield bonds, equities, leveraged bank loans and so on—can vary widely.
Take high-yield bonds, a major ingredient in any high-income strategy. Over time, high-yield bond returns have more in common with stock returns than with returns on other types of bonds. But there’s one important difference: high-yield bonds are about half as volatile as equities and offer more downside protection.
This argues not for abandoning high yield late in the credit cycle, but for owning high yield to help reduce downside risk. In fact, by shifting some equity exposure to high yield, investors can de-risk the overall portfolio while only modestly curbing its return potential. We think investors can dampen volatility even further by focusing on shorter-maturity high-yield bonds, which tend to do better when Treasury and credit yield curves are flat, as they are today.
It also helps to take the long view. Volatility comes and goes, but investors who maintain exposure to high-yield debt across market cycles have been rewarded for it. That’s because yield is a remarkably reliable indicator of the total return investors can expect to earn over the next five years. The yield-to-worst of the global high-yield market was 5.7% as of December 31, 2019. That’s a hard figure to ignore in today’s environment of low to negative government bond yields.
Diversify Your Income
Investors looking to boost their yield should apply a global lens and think outside the corporate-credit box when considering potential investments. By adding other return-seeking assets to the mix, investors can lift income potential and improve downside protection. Some of the high-income opportunities we see today include subordinated European financial bonds, select emerging-market debt and US securitized assets.
Subordinated European bank debt was issued to comply with the global Basel III regulations that required banks to build up equity capital buffers. These securities continue to offer attractive yields to compensate investors for the risk they’re taking by buying a bond that’s further down in the capital structure.
In fact, because of their position in the capital structure, subordinated bonds issued by investment-grade banks offer yields like speculative-grade securities. Yields on European additional Tier 1 (AT1) bonds, the first securities that would take a hit if the issuing bank ran into trouble, comfortably outstrip those on European and US high-yield bonds.
While developed-market banks are generally in good health today, European bank debt is particularly attractive because European financials are in a slightly earlier stage of the credit cycle than their US counterparts.
US securitized assets are also a good way to boost portfolio income while helping to offset geopolitically driven volatility. Commercial mortgage-backed securities (CMBS) and credit risk–transfer (CRT) securities—residential mortgage-backed bonds issued by US government-sponsored enterprises—have weathered the ups and downs of the US-China trade war, for instance, better than US high-yield credit. They also have low correlations with other fixed-income sectors and other asset classes.
Lastly, valuations are also broadly attractive in emerging markets, whose economic fundamentals have meaningfully improved in recent years. Emerging-market debt (EMD) benefited from global central banks’ dovish tilt in 2019, and we think that EMD may get an added boost as monetary policy gets even easier in 2020. In the year ahead, however, differences among EMD winners and losers could be pronounced, underscoring the need to be discerning.
Harness the Wind
A world of low yields and high volatility can feel especially perilous to income-starved investors. But abandoning high-income assets or investing in single-sector income strategies can be riskier—especially in an uncertain, late-cycle environment.
In our view, a global high-income strategy diversified across sectors is most likely to offer the strong return potential and downside protection today’s investors crave.
- Gershon Distenfeld
- Co-Head—Fixed Income & Director of Credit