High Time for High Income
Gershon Distenfeld: Will, many investors are unnerved today. There are a lot of headwinds in markets. Despite that, we think there's a pretty good opportunity in credit, particularly high yield. Why is that?
Will Smith: It's for the very simple reason that companies came into this volatile period in really strong fundamental shape.
GD: Spreads have widened quite a bit here. Usually, widening spreads result in higher defaults. We don't think that's going to be the case this time. Can you elaborate on that?
WS: Absolutely. So, 2020 we had about 6% of the high-yield market file for bankruptcy. So, the weakest names just two years ago fell out of the investment universe, and the names that continue to be in the high-yield space survived COVID and have really improved their fundamental stories since then. So, when we look at the current economic slowdown that we expect, we actually think defaults will remain below average for quite some time.
GD: One of the lessons I've learned in my 25 years in the business is that attractive valuations could still get even more attractive in the short term, rich valuations, expensive valuations, can continue to do well, but there seems to be a much higher correlation with yields and longer-term returns.
WS: When you look at historical numbers, even if you were to buy a high-yield portfolio at a very bad point in the cycle—i.e., like, '07, bought a high-yield one at 7% yields—I think people are generally very surprised when I say after five years of being invested, you earned about 7%, even though spreads went a lot wider, we had big default rates. There's a lot of things that happened, but at the end of the day, those all-in returns ended up being pretty close to your starting yields. And we think there's no reason to believe that won't hold going forward. For an investor that has a longer-term horizon, if you stack up those current levels of yields at 7% for high yield, we think that's a pretty compelling value proposition over the next five years.
GD: Now, traditionally investors have viewed high yield as part of the fixed-income markets, rightfully so, they are fixed-income instruments, but one can make a compelling case that you should compare high yield to the equity markets because of the higher correlation there.
WS: Absolutely, and if you look at the history, it suggests that high yield is much more like an equity asset class than it is a government bond one. And when we think about today's environment, for investors that want to de-risk their portfolio in some way, we think a very logical way to do that today is to actually reduce your stock portfolio, which might continue to be pretty volatile with all the macro headwinds that we're facing. And instead replace it with a high-income-producing asset class, like high yield, that has significantly less volatility.
GD: One of the most frequent questions I get asked today is, given that rates are going to rise, why would I invest in fixed income now? Let me just wait on the sidelines and invest when yields go up even further. How would you respond to that?
WS: I think it's a very dangerous game to play. When we're talking about income-producing assets, your income accrues daily. And so every day you're on the sideline, you're missing that accrual.
GD: The passage of time is where you earn all of your return in fixed income, and just the odds of meeting your investment goals over any reasonable horizon is much lower when you're not fully invested.
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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.
Will Smith is 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.
A disciplined process that focuses on a variety of approaches—including quantitative, liquidity and macro models—to generate returns is key to Smith’s investment philosophy. This is an aggressive style within tight limits, one that emphasizes risk management and a longer investment horizon.
“Building better credit portfolios isn't just about humans doing deep research,” Smith says. “It’s focusing that research where and when other approaches won’t be as effective.”
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.
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