Asset Allocation Volatility Fixed Income Blog

Looking to De-Risk? High Yield Can Help

29 April 2019
2 min read
Looking to De-Risk? High Yield Can Help
Gershon M. Distenfeld, CFA | Director—Income Strategies
Will Smith, CFA| Director—US High Yield

The S&P 500 Index hit an all-time high on April 23, thanks to improving investor optimism. But for some equity investors, market highs signal a good time to reduce downside risk.

There are additional reasons investors may want to trim their sails. We’re nearing the end of one of the longest credit cycles on record. And the US yield curve has flattened—historically a signal of slower growth or possibly a recession ahead. Market conditions are likely to get rough.

That’s why it’s time to remind investors that—while equities should continue to comprise a very large part of a portfolio—a complementary allocation to high yield can be healthy.

Want Lower Volatility? Consider High Yield

Investors can efficiently lower their overall risk while only modestly curbing potential returns by shifting a modest allocation away from US equities and into US high yield (Display).

High-Yield Bonds and Equities: Effective Complements

A Combination of High Yield* and Equities† Has Historically Improved Risk-Adjusted Returns

High-Yield Bonds and Equities: Effective Complements

As of December 31, 2018.
Past performance is not a guarantee of future results. There can be no assurance that an actual portfolio based on the hypothetical portfolio underlying the above illustration could be created or, if created, that it would achieve the results implied above or be profitable.
Diversification does not illuminate risk of loss.
*Based upon a hypothetical portfolio; accordingly, such performance is not based upon historical performance of any investment portfolio. This illustration is not intended to provide either a complete analysis regarding any or all of the variables that could affect any particular portfolio. High-yield is represented by Bloomberg Barclays US corporate high-yield.
†Equities is represented by S&P 500 index. All indices cited hearing are used for purposes of comparison purposes only. An investor generally cannot invest directly in an index, and its performance does not reflect the performance of any AB portfolio.
Source: Bloomberg Barclays, S&P and AllianceBernstein (AB)

How is this possible?

First, high-yield bonds provide investors with a consistent income stream that few other assets can match. This income—distributed semiannually as coupon payments—is constant. It gets paid in bull markets and bear markets alike. It’s the main reason high-yield investors have historically looked at starting yield as a remarkably reliable indicator of future returns over the next five years—no matter how volatile the environment. After accounting for maturities, tenders and callable bonds, the high-yield market typically returns anywhere from 18% to 22% of its value every year in cash.

Along with these payments, high-yield bonds also have a known terminal value that investors can count on. As long as the issuer doesn’t go bankrupt, investors get their money back when the bond matures. All this helps to offset stocks’ higher level of volatility—and provide better downside protection in bear markets.

Average calendar year returns for the S&P 500 and the Barclays US High-Yield Index between 1998 and 2018 were 8.2% and 7.4%, respectively. But the average drawdown for stocks over that period was 11.0%, nearly twice high-yield’s tally of 5.7%.

Recovering Losses Quickly

Some of high-yield’s advantage comes down to valuations. As spreads widen, high-yield bonds’ income-generating potential grows, and investors can reinvest their proceeds at higher yields. And if spreads widen in 2019, causing short-term price declines, investors can take comfort in knowing that high yield tends to make up its losses more quickly than stocks do.

For instance, the high-yield market has suffered 10 peak-to-trough losses of greater than 5% over the last 20 years. On average, investors recovered their losses from those drawdowns in less than six months—and sometimes in as few as two. Meanwhile, stock markets have seen much larger losses and have taken longer to recover from drawdowns.

Of course, it’s still critical to choose your exposures carefully. It’s late in the credit cycle and default rates will likely rise this year. And companies with high debt levels are likely to remain highly sensitive to signs of slower growth.

But over the long run, we’ve seen that adding a dash of high-yield debt to an equity portfolio can tamp down volatility without sacrificing too much return potential. When markets are volatile, that’s a reassuring thought.

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.

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.”

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