Why High-Income Investors Who Spread Themselves Thin Get It Right

Tighter monetary policy in advanced economies. Stretched asset valuations. These are anxious times for income-oriented investors. But don’t worry—it’s still possible to generate income without taking on unnecessary risk.

If you’re a high-yield bond investor, you’ve probably been hearing a lot about how the US credit cycle is drawing to a close. You may even have heard something to that effect from us.

So, is it time to weigh anchor and leave high yield? Hardly. Pulling out simply isn’t an option for investors who rely on their portfolios to deliver a high level of income.

But it may be time to reexamine your high-income strategy. Markets are nearing an inflection point, with central banks finally moving away from quantitative easing, and credit conditions around the world vary. In our view, success in these conditions calls for a global, multi-sector approach that’s focused on reducing risk and maximizing opportunity.

In other words, don’t abandon high-yield bonds. Diversify by adding multiple sources of income to your high-yield allocation. The thinner investors can spread themselves, the better.

Scouting the Markets and the Globe

Why is this approach so important? Because credit cycles, which track the expansion and contraction of credit in an economy, vary.

Investors often speak of a single credit cycle, but there are nearly always multiple cycles under way in different sectors and parts of the world. And they all have distinct stages.

For instance, many US assets, including leveraged bank loans and many high-yield and investment-grade corporate bonds, are nearing the contraction stage. This usually coincides with rising borrowing costs, higher debt levels, stingier lenders and a potential decline in asset prices.

Others, such as European financials and Latin American industrials are either in the repair or recovery phase, a period when credit quality and return potential usually improve (Display).

Plenty of Attractive Opportunities

A global, multi-sector approach diversifies interest-rate and economic risk, and helps investors to home in on a promising mix of return potential and credit quality by getting access to assets at different stages of the credit cycle.

Emerging-market debt, for example, offers high inflation-adjusted, or “real,” yields and benefits from improving fundamentals and growth in many developing countries. Meanwhile, financial bonds from European issuers boast attractive valuations and are in the recovery stage of the cycle.

Within the US, investors may want to consider securitized assets, which are closely tied to the health of US consumers and the recovering US housing market.

Don’t Forget High Yield

US high yield also belongs in a well-diversified portfolio, even at this late stage of the credit cycle. A hands-on approach can uncover opportunities in select sectors. Investors who want to limit potential volatility may want to consider shortening durations and avoiding CCC-rated junk bonds, which tend to be most vulnerable in a rising-rate environment.

High yield also has a history of bouncing back quickly from market downturns and better—and more predictable—return potential than do other high-income assets, including leveraged bank loans.

Even in uncertain times, there’s no reason to resign yourself to lower returns. The global bond market is vast. Those who want to maintain a high level of income should be willing to go far and wide to secure it.