Fixed Income Blog

New Year's Resolutions for High-Income Investors

03 December 2018

4 min read

Gershon M. Distenfeld, CFA | Director—Income Strategies

Will Smith, CFA| Director—US High Yield

First, the bad news: high-income investors should saddle up for another bumpy ride in 2019. Now the good: with challenges come opportunities—and we see plenty on the horizon for investors who take the long view.

We expect global growth to slow next year, inflation to rise, and tight market liquidity to get even tighter. That won’t come as a big surprise to most investors. After several years of expansion, large economies such as the US and China are moving into the later stages of the credit cycle, and global interest rates are rising. That adds up to more volatility ahead.

Seeing the big picture in conditions like these isn’t easy. When markets are volatile, it can be tempting to pull your money out at the latest bit of bad news. But for most investors, abandoning a high-income strategy simply isn’t a viable option.

So, how can investors make the most of next year’s opportunities? We recommend the following New Year’s resolutions:

Resolution No. 1: Make the World Your Investment Universe

In 2018, the most attractive opportunities were concentrated in the US. That’s because US assets benefited from a booming US economy and strong corporate earnings. Elsewhere, growth was less robust, and rising interest rates and a stronger US dollar put pressure on many non-US assets, including emerging-market (EM) bonds and currencies.

This type of divergence is unusual, though, and we’re not betting on a repeat performance in 2019. After having struggled this year, many non-US credit assets are attractively valued today. European high-yield bonds, for example, now offer more value than their US counterparts (Display).

European High Yield: The Price May Be Right

Through November 26, 2018
Source: Bloomberg Barclays

European high yield also stands to benefit from looser monetary conditions. The European Central Bank will likely end emergency asset purchases this year, but it isn’t likely to start raising interest rates until late in 2019. In particular, we see value in subordinated European financial bonds, which offer attractive yields to compensate investors for the risk they’re taking by buying a bond that’s further down the capital structure.

A renewed focus on Europe can benefit both euro-based and dollar-based investors. The former can save on the prohibitive cost of hedging their dollar exposure, while the latter can boost their returns by hedging back to the higher rate of the US currency.

Valuations are also broadly attractive in EM debt, another sector that struggled this year. Of course, fundamentals matter, too. Based on valuation alone, a local-currency sovereign bond yielding 40% may look like a screaming buy. The picture gets fuzzier, though, if the issuing government is struggling to contain inflation and running high deficits.

The best managers, in our view, can seize opportunities and still avoid overconcentration in any one country or region. That requires detailed fundamental analysis and a global, multi-sector strategy that seeks to access EM returns in the most diversified manner possible.

Resolution No. 2: Keep Track of Credit Cycles

The US is further along in the credit cycle than other major economies, and we expect the Federal Reserve to hike rates up to four times next year. That means investors should step lightly in areas that have seen massive credit expansion, such as leveraged bank loans and some sectors of the corporate bond markets.

But here’s the thing about the credit cycle: there isn’t just one—even within a single economy. There are nearly always multiple cycles under way. Some sectors of the US high-yield bond market have already moved through the contraction phase of the cycle and are now in the repair or recovery phase.

The 2014–2015 oil price plunge, for example, drove more than 100 energy companies into bankruptcy. But those that survived, cut costs and deleveraged are now in better shape to withstand future economic weakness, including the current—and less foreboding—decline in commodity prices. Likewise, many pharmaceutical firms have cleaned up their balance sheets and seen their earnings stabilize.

Resolution No. 3: Don’t Dwell on Defaults

Does this mean investors should expect more defaults in sectors that haven’t gone through a credit contraction yet? Possibly. But we think the companies most at risk are those in sectors like retail that have seen their competitive positions erode. Higher rates could push some of these issuers over the edge.

But it’s hard to envision a broad rise in defaults across the market. That’s because US and global growth, while likely to slow, should remain solid. Solid growth allows companies to deleverage and generate free cash flow. What’s more, many high-yield issuers have rarely looked stronger, with manageable leverage, strong balance sheets and solid earnings potential.

Resolution No. 4: View Higher Rates as an Opportunity

Economic growth helps explain why high-yield bonds tend to do well when interest rates rise. Between April 1990 and December 2017, the Bloomberg Barclays US Corporate High-Yield Index delivered an average monthly return of 0.9% in months when the US five-year Treasury yield rose, and 0.6% when it fell.

And for investors with long investment horizons, higher rates are good news because they mean higher returns. This goes for all bonds, but it’s especially important in high-yield bonds because the average life of a high-yield bond is just four or five years. Maturities, tenders and calls mean that the typical high-yield portfolio returns roughly 20% of its value every year in cash, allowing investors to reinvest the money in newer—and higher-yielding—bonds.

Resolution No. 5: Prepare for Bouts of Illiquidity

Most higher-yielding assets carry varying degrees of liquidity risk—that is, how easy it is to buy or sell an asset without drastically affecting its price. In volatile markets, it can be difficult to sell credit assets quickly, even high-quality ones that may have appeared reasonably liquid in calmer conditions.

As access to credit tightens, we would expect some of the lower-credit-quality assets, such as some CCC-rated “junk” bonds and leveraged bank loans, to struggle. Instead, investors will want to prioritize bonds from companies with clean balance sheets and strong business models and governments from countries with solid macroeconomic fundamentals and prudent policies.

Investors who have done their credit homework and know what their assets are worth will be able to sit tight through periods of high volatility and low liquidity. But those who reached for the highest yields without regard to credit quality or liquidity risk may find it hard to unload those assets without taking big losses.

Just as importantly, investors who keep some cash on hand will be in a position to buy attractively priced assets when others are desperate to sell.

We expect markets to be less predictable in 2019. But long-term investors who resolve to follow a global, multi-sector strategy stand the best chance of long-term success.

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.

About the Authors

Gershon M. Distenfeld, CFA

Gershon Distenfeld is a Senior Vice President, Director of Income Strategies and a member of the firm’s Operating Committee. He is responsible for the portfolio management and strategic growth of AB’s income platform with almost $60B in assets under management. This includes the multiple-award-winning Global High Yield and American Income portfolios, flagship fixed-income funds on the firm’s Luxembourg-domiciled fund platform for non-US investors. Distenfeld also oversees AB’s public leveraged finance business. He joined AB in 1998 as a fixed-income business analyst and served in the following roles: high-yield trader (1999–2002), high-yield portfolio manager (2002–2006), director of High Yield (2006–2015), director of Credit (2015–2018) and co-head of Fixed Income (2018–2023). Distenfeld began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. He holds a BS in finance from the Sy Syms School of Business at Yeshiva University and is a CFA charterholder. Location: Nashville

Will Smith, CFA

Will Smith is a Senior Vice President and Director of US High Yield Credit. He is also a member of the High Income, Global High Yield, Limited Duration High Income, Short Duration High Yield and European High Yield portfolio-management teams. Smith designed and is one of the lead portfolio managers for AB’s Multi-Sector Credit Strategy, which invests across investment-grade and high-yield credit sectors globally. He leads the monthly High Yield portfolio-construction meeting, and is a member of the Credit Research Review Committee, which determines investment policy for the firm’s credit-related portfolios. Smith has authored several papers and blogs on high-yield investing, including one on the importance of using a probability-based framework to build better portfolios. He joined AB in 2012, and spent 2014 in London as part of the European High Yield portfolio-management team. Smith started his career with UBS Investment Bank, working as an analyst with the Credit Risk team and then later on the Fixed Income sales and trading desk. He holds a BA in economics from Boston College and is a CFA charterholder. Location: Nashville

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