Balancing Risks as the Credit Cycle Turns

14 November 2024

5 min read

John Taylor| Head—European Fixed Income; Director—Global Multi-Sector

Balancing credit risk with interest-rate risk in a dynamically managed portfolio can be an all-weather approach.

Central banks across the US, UK and Europe have shifted to an easing phase, signaling a change in the credit cycle. The chances of a soft landing for the global economy look promising, in our view. Yet the downside risks could be high; geopolitical conflicts, record peace-time debt burdens and the lingering aftermath of COVID make for an exceptionally unpredictable backdrop.

Hence, risk-aware bond investors need portfolio strategies that can both capture opportunities and cope with periods of high volatility and sudden drawdowns. We think it’s timely to consider a dynamic barbell approach that combines defensive high-quality bonds with higher-yielding credits.

Playing Too Safe Wastes Opportunities

A traditional investment-grade multi-sector bond portfolio offers clear attractions: low default risk combined with a modest yield pickup over Treasuries in a readily understood package. Even so, this approach comes with an opportunity cost. An investment-grade-only portfolio misses out on the benefit of wider diversification, which creates the opportunity to manage risk more efficiently and potentially achieve higher income and better risk-adjusted returns.

Taking the US as an example, a simple 50/50 passive “barbell” combination of US Treasuries with US high-yield bonds rated BB or B has historically produced better outcomes than both BBB-rated US corporate bonds and the broader US Aggregate Index across a range of metrics. These include higher income, lower volatility, less interest-rate risk (duration), and higher risk-adjusted returns (Display)—features that have characterized the barbell approach over time.

Historically, Barbell Approach Has Generated Better Characteristics

Over the last 10 years the barbell had a higher yield-to-worst, lower duration and higher five-year Sharpe ratio.

Current and historical analyses do not guarantee future results.
Barbell represented by 50% Bloomberg US Treasury Index and 50% Bloomberg US High Yield Ba/B 2% Issuer Capped Index; BBB by Bloomberg US Corporate Baa Index; US Aggregate by Bloomberg US Aggregate Index. Average Sharpe Ratio is calculated using monthly five-year Sharpe ratios from November1, 2014, through October 31, 2024.
As of October 31, 2024
Source: AllianceBernstein (AB)

Data for euro and global markets over the same time frame show similar patterns: higher income and risk-adjusted returns, with mostly lower duration and comparable volatility.

Combine Negatively Correlated Assets

A credit barbell combines interest-rate-sensitive bonds with higher-yielding credit assets because their returns are usually negatively correlated. When riskier, growth-oriented credit assets such as high-yield bonds fall in value, government bonds and other interest-rate-sensitive assets usually rise, and vice versa. Because negatively correlated assets tend to take turns outperforming each other, investors can sell the outperformers on one side (for instance, high-quality high yield) and buy the cheaper bonds on the other (for example, Treasuries). That approach has historically tended to increase returns over time.

In our 50/50 barbell example, we used US Treasuries to represent interest-rate risk and US high yield as a proxy for credit risk. The investment-grade portfolio underperformed this barbell because it lacked enough exposure to credit risk to generate higher income and returns. Credit risk is typically well compensated with income. Using option-adjusted spread divided by volatility as a measure of income per unit of risk, we can see that US high yield is a very efficient income generator (Display).

High Yield Generates Most Income per Unit of Risk

Option-Adjusted Spread Divided by Five-Year Volatility

US high yield generates three times more than US investment grade corporates and 30% more than the 50/50 barbell.

Current analysis does not guarantee future results.
Indices used: Bloomberg US Aggregate Index, Bloomberg US Corporate Investment-Grade Index, Bloomberg US Corporate Baa Index, 50% Bloomberg US Treasury and 50% Bloomberg US High Yield Ba/B 2% Capped Index, J.P. Morgan EMBI Global Diversified Index, Bloomberg US Corporate High Yield Index
As of October 31, 2024
Source: Bloomberg and J.P. Morgan

Both global and euro data show similar rankings to the US, with high yield clearly the most efficient income generator.

The income contribution from high yield is critical. Historically, the biggest component of bond returns has come from income payouts to bondholders rather than capital appreciation. In fact, over the last 20 years, US high-yield bonds’ annual return due to income has slightly exceeded annual total return. Hence, a strategy that is underexposed to income per unit of risk will likely struggle to generate attractive returns for risk-conscious investors.

Aim for the Right Balance

What’s the right mix of assets? That depends on each investor’s needs and comfort level. A simple 50/50 split could be right for an investor with high income requirements and a high risk tolerance, because credit assets are at least twice as volatile as high-quality government debt. So when it comes to risk exposure, an even split between the two asset classes effectively tilts toward credit.

An investor who wants a more balanced exposure would likely incline toward a 65% Treasuries / 35% high-yield allocation, giving up a small amount of return in exchange for lower risk. In practice, investors seeking an optimal mix would also likely allocate to a wide variety of higher-yielding fixed-income sectors, including not only high-yield bonds but also corporate and hard-currency emerging-market debt, inflation-linked bonds and securitized assets.

Most important, we believe keeping the right balance involves an active, dynamic approach that explicitly manages the interplay of rate and credit risks. To that end, credit barbells offer an advantage: combining diversifying assets in a single portfolio makes it easier to manage risk and tilt toward duration or credit according to market conditions.

Choose Horses for Courses as Economies Diverge

The challenges facing the world’s three biggest economic drivers—the US, Europe and China—have become increasingly diverse. As a result, we expect rate paths and risk-asset valuations to continue to diverge as well. This divergence creates opportunities for investors and particularly for dynamic barbell approaches, in our view.

In the eurozone, for instance, we think pockets of the high-yield markets appear especially attractive, while segments of the European government bond markets look reasonably priced to us, considering their defensive characteristics. If growth disappoints or markets turn down, the European Central Bank (ECB) has plenty of scope for deeper rate cuts than the market expects, in our analysis. By contrast, the US economy looks stronger, and the Fed is less likely to cut rates as fast or deep, in our view.

We think high-yield credit remains an attractive component of a barbell strategy for several reasons, even though spreads are currently tight. These include both current advantages (such as compellingly high yields and robust fundamentals), and structural performance benefits resulting from the mechanics of upgrades to and downgrades from investment grade.

Across global markets, however, low-quality CCC-rated securities account for the bulk of defaults; steering clear of these bonds might make sense when economic conditions are getting tougher. This approach would concede a small amount of return in exchange for significantly lower default risk.

Active Management Can Add Value

There’s no one way to build a well-diversified portfolio. But it’s important to vet potential managers carefully to learn about their investment process and approach to balancing interest-rate and credit risks. Knowing which way to lean—and when—requires a deep understanding of the interest-rate and credit cycles around the world and how they interact.

We think a portfolio that dynamically balances high-quality and high-income bonds has the potential to weather most markets and represents a more efficient approach than a stand-alone investment-grade multi-sector mandate. In an unstable world, it’s important to keep your balance.

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. Views are subject to revision over time.

About the Authors

Scott DiMaggio, CFA

Scott DiMaggio is a Senior Vice President, Head of Fixed Income and a member of the Operating Committee. As Head of Fixed Income, he is responsible for the management and strategic growth of AB’s fixed-income business and investment decisions across the department. DiMaggio has previously served as director of Global Fixed Income and continues to be a portfolio manager across numerous multi-sector and multi-currency strategies. Prior to joining AB’s Fixed Income portfolio-management team, he performed quantitative investment analysis, including asset-liability, asset-allocation, return attribution and risk analysis for the firm. Before joining the firm in 1999, DiMaggio was a risk management market analyst at Santander Investment Securities. He also held positions as a senior consultant at Ernst & Young and Andersen Consulting. DiMaggio holds a BS in business administration from the State University of New York, Albany, and an MS in finance from Baruch College. He is a member of the Global Association of Risk Professionals and a CFA charterholder. Location: New York

John Taylor

John Taylor is Head of European Fixed Income and Director of Global Multi-Sector at AB. He is a senior member of the Global Fixed Income, UK and European Fixed Income, and Absolute Return portfolio-management teams. Prior to this, Taylor was responsible for the management of single-currency portfolios. He joined the firm in 1999 as a fixed-income trader and was named in Financial News’s 40 Under 40 Rising Stars in Asset Management in 2012. Taylor holds a BSc (Hons) in economics from the University of Kent. Location: London