Fixed Income Blog

A High-Income Survival Guide for Late-Cycle Markets

24 October 2019
4 min read
A High-Income Survival Guide for Late-Cycle Markets
Gershon M. Distenfeld, CFA | Director—Income Strategies
Noelle Chiang, CFA| Director and Senior Investment Strategist—Fixed Income

It’s easy to get spooked in late-cycle markets. But we think there’s a way to de-risk your portfolio and still generate a decent level of income—no magic spells necessary.

Investors often do one of the following things when markets are in the later stages of the credit cycle:

  • Some react to slower growth and falling interest rates by stretching for more yield in CCC-rated corporate bonds, preferred stocks 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.

The way we see it, neither approach stands much chance of helping investors reach their goals. The first exposes them to too much risk—likely with inadequate compensation—while the second is bound to limit income potential and may not reduce risk by as much as people think.

What’s the alternative? Simple: globalize your high-income strategy and look for opportunities across fixed-income sectors. This diversifies a portfolio, which increases income potential and reduces downside risk. Both are important because the risk associated with “risk assets”—high-yield bonds, equities, leveraged bank loans and so on—varies considerably.

Not All Risk Assets Perform Equally

Put another way, some risk assets are riskier than others. Take high-yield bonds, a building block of any high-income strategy. Over time, high-yield performance has more in common with stocks than other types of bonds, but with one important difference: it’s about half as volatile.

As Display 1 shows, global high-yield returns were not far below those from the MSCI World Index of global stocks over the past decade. And they comfortably outpaced what a 60/40 stock-bond portfolio delivered. But high yield offered more downside protection and was less volatile than either one, giving it a higher risk/return ratio.

Some Risk Assets Are Less Risky than Others
Some Risk Assets Are Less Risky than Others

Data are from September 30, 2009, to September 30, 2019. Historical analysis does not guarantee future results. Individuals cannot invest directly in an index. Global High Yield is represented by Bloomberg Barclays Global High Yield Corporate Index (USD hedged), Global Stock is represented by MSCI-World Index and 60/40 Portfolio is represented by 60% MSCI World Index + 40% Bloomberg Barclays Global-Aggregate Index. Monthly data
Source: Bloomberg, Bloomberg Barclays, MSCI and AB

Here’s another way to think about this: investors who consider high yield too risky to own late in the cycle should be even more frightened of owning equities. Now, we’re not suggesting that they abandon either one; both belong in a diversified investment portfolio.

But by shifting some equity exposure to high yield, investors can end up lowering portfolio risk while only modestly curbing return potential. We think investors can dampen volatility even further by focusing on shorter-maturity high-yield bonds, which tend to do better when the US Treasury and credit yield curves are flat, as they are today.

The worst thing investors can do, in our view, when the outlook darkens and volatility spikes is to trade all their high-yield exposure (and their equities, for that matter) for investment-grade corporate debt and high-quality government bonds. In today’s low-yield world, this can make it very tough to produce the income so many investors need.

We think it helps here 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. This is because the yield you start with is a remarkably good indicator of what you can expect to earn over the next five years. Today’s yield-to-worst for the broad global high-yield market—the lowest likely return you should get—is nearly 6.2%. That’s a hard number to ignore when the 10-year US Treasury yield sits at just 1.75% and comparable Japanese and German yields are well below zero.

Go Global

Of course, active security selection is as important in the high-yield market today as it is anywhere else. We think a global lens can help.

For instance, we see select opportunities in European high-yield bonds, which are broadly higher in quality than their US counterparts. This is especially so for US dollar–based investors, who can boost returns by hedging back to the higher rate of the US currency (Display 2).

Euro High Yield: Opportunity for USD-Based Investors
Euro High Yield: Opportunity for USD-Based Investors

As of September 30, 2019
Historical and current analyses do not guarantee future results. Hedging costs are estimated and will vary over time.
Hedge: A hedge is an investment to reduce the risk of adverse price movements in an asset, such as taking an offsetting position in a related security.
EUR HY denoted by Bloomberg Barclays Euro High Yield Index, US HY denoted by Bloomberg Barclays US High Yield Index.
Source: Bloomberg Barclays and AB

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. These securities also benefit from solid banking-sector fundamentals

Diversify Your Portfolio, Dispel Your Fears

The next step to a more sustainable high-income strategy, as we see it, is to add other return-seeking assets to the mix. As Display 3 illustrates, many offer more attractive combinations of yield and quality today than high-yield bonds do.

In Credit, Look Beyond Traditional High-Yield Bons

Many Sectors Offer Better Combinations of Yield and Quality than US High Yield (HY)

In Credit, Look Beyond Traditional High-Yield Bons

Through September 30, 2019
Past performance and historical and current analysis do not guarantee future results. 
*CMBX is an index that tracks the commercial mortgage-backed securities market †AT1: additional tier 1 bonds are subordinated bank debt that can be written off in a crisis EM: emerging-market; IG: investment-grade
Source: Bloomberg Barclays and J.P. Morgan

US residential and commercial mortgage-backed securities have proved more resilient than other credit assets to trade tensions and other geopolitical risk. The former benefit from a solid US housing market, while the latter have been driven down in price due to what we consider an excessively gloomy outlook for US shopping malls that back some of the loans. Both offer a healthy yield pickup over similarly rated corporate debt.

Valuations are also broadly attractive in emerging-market debt, which offers a significant yield pickup over developed-market bonds. What’s more, inflation is low in most emerging economies, providing room for central banks to cut rates, and economic fundamentals are solid.

We’re living in a world of low yields and high volatility—and we don’t expect that to change soon. This is a frightening thought, we know. But investing in single-sector income strategies or abandoning high-income assets entirely can be even scarier, especially in an uncertain, late-cycle environment. In our view, a global high-income strategy diversified across sectors is most likely to offer strong return potential and downside protection.

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

Gershon M. Distenfeld thrives on facing challenge, solving problems and putting people with different personalities and different viewpoints together to "make the engine run." When he joined AB in 1998 from a role as an operations analyst at Lehman Brothers, Distenfeld had long been fascinated by the high-yield market, and he led that practice at AB from 2006 to 2016 before assuming responsibility for all of credit. He has been co-head of fixed income since 2018.

In an industry that tends to focus on the short term, Distenfeld's investment philosophy takes the long view, considers a range of outcomes and focuses on the downside. This approach puts process and constant innovation at the forefront, making full use of AB's proprietary technology to mine the insights of fundamental and quantitative research.

"We're constantly reinventing ourselves," Distenfeld says. "We don't just sit still. We adapt to new information so we can find new factors that work."

Distenfeld's eye toward the long view extends to his charitable work with organizations like New Jersey NCSY. This youth organization for disaster relief partners with Habitat for Humanity and NECHAMA to repair homes and lives affected by natural disasters.

Noelle Chiang is a Director and Senior Investment Strategist, heading the Fixed Income Business Development team in Taiwan. She joined AB in 2012 as a product manager specializing in fixed income. Previously, Chiang was a fund manager at UBS Asset Management and PineBridge Investments. Prior to that, she was responsible for derivatives trading and structured product design and development for security companies. Chiang has worked in global financial markets since 2000. She holds a BS in economics and an MBA in finance from National Taiwan University, and is a CFA charterholder. Location: Taipei