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.
