Volatility Fixed Income Blog

Want Sustainable Income? Spread Your Risk Around

11 May 2018
3 min read
Want Sustainable Income? Spread Your Risk Around
| Director—Income Strategies

Investors often say they’re worried about having too much high-yield bond exposure so late in the credit cycle. But many are still chasing returns in equities and other assets with even higher risk. We’ve got a better idea.

Don’t get us wrong. We recognize how tough it is to generate income in today’s low-yield environment. But as we’ve pointed out before, the best way to boost income potential at this stage in the cycle without also boosting drawdown risk is to have a diversified high-income strategy that embraces multiple sectors and regions.

Today, we fear that too many investors are moving in the opposite direction, taking highly concentrated positions in high-risk assets and sectors in hopes of generating higher returns. Through April 30, investors poured $57.2 million into offshore open-ended mutual and exchange-traded funds that invest in equities, according to Morningstar. But they yanked $14.1 million out of global high-yield funds.

Some investors may not realize that overconcentrating in one asset or sector can expose them to higher-than-expected levels of volatility. The higher the level of volatility, the less predictable return streams are. This means investors may have to rely on larger upswings to make up for losses when they occur.

High-yield bonds and equities are both strongly linked to the business results and fundamentals of the companies they represent, making them both highly correlated with economic growth and the credit cycle. But investors who think they’re de-risking their portfolios by reducing exposure to the former while maintaining it to the latter may be disappointed.

Why? Because high-yield bonds have historically had lower volatility, even during some of the more tumultuous periods for capital markets. And over the long term, high yield has produced equity-like returns with about half the risk of equities (Display).

High-Yield Bonds: Historically Less Volatile than Equities
High-Yield Bonds: Historically Less Volatile than Equities

As of March 31, 2018
Historical analysis does not guarantee future results.
Global high yield represented by Bloomberg Barclays Global High-Yield (hedged to USD) and international equities represented by MSCI World (hedged to USD).
Source: Bloomberg Barclays, Morningstar Direct, MSCI and AllianceBernstein (AB)

Looking for Yield in All the Right Places

Both high-yield bonds and equities deserve a place in any well-diversified portfolio. But the way we see it, it makes more sense to embrace a global, multi-sector strategy than to overconcentrate in either one. This approach offers a more predictable stream of income while diversifying sources of high income and risk when compared with strategies that take concentrated and single-sector bets in pursuit of higher yield.

Moreover, having a wide range of income generators is important because different sectors outperform at different times (Display).

No Bond Sector Leads All the Time

In US Dollars

No Bond Sector Leads All the Time

Through December 31, 2017
Past performance does not guarantee future results. These returns are for illustrative purposes only and do not reflect the performance of any fund. Diversification does not eliminate the risk of loss. US HY is represented by Bloomberg Barclays US Corporate High-Yield; EMD local by J.P. Morgan GBI-EM Global; Asia credit by J.P. Morgan Asia Credit; EM HY by J.P. Morgan EMBI Global Non-Investment Grade; EM corporates by J.P. Morgan CEMBI Broad Diversified; bank loans by Credit Suisse Leveraged Loan; EUR HY by Bloomberg Barclays Pan-Euro High-Yield (USD hedged). An investor cannot invest directly in an index or average, and they do not include sales charges or operating expenses associated with an investment in a mutual fund, which would reduce total returns.
Source: Bloomberg Barclays, Credit Suisse, J.P. Morgan and AllianceBernstein (AB)

Today, we see attractive opportunities in many US securitized assets, including credit risk–transfer securities, a new type of floating-rate mortgage-backed bond issued by the US government–sponsored housing agencies that should benefit when short-term rates increase.

Select emerging-market (EM) bonds look attractive, too, in large part because more governments have reined in their deficits and embraced tighter fiscal policies and good governance. In particular, we see value in certain local-currency-denominated securities, which offer higher real yields and help diversify exposure to US dollar–denominated bonds.

Again, though, overconcentration in just a few EM countries or sectors—some of which offer very high yields—is risky. That’s why it’s so important to be selective and diversified.

Don’t Abandon High-Yield Bonds

Picking your spots in high yield is just as important. But continued global growth suggests there’s still plenty of value to be had in this market. We see opportunities in the energy sector, where many issuers reduced leverage following the sharp decline in commodity prices in 2014 and 2015. And because the energy sector’s reputation has been damaged by the recent sell-off, energy bond valuations have not yet recovered.

We also see value in pockets of the banking sector—especially European banks that are earlier in the credit cycle than US industrial companies. These banks have solid balance sheets and continue to improve their capital ratios.

A Steady Hand on the Wheel

One more thing: weaving together an effective multi-sector high-income strategy is a complex undertaking that requires a thorough understanding of how different investments can impact risk and returns in different market environments. That’s why it’s important that investors or their managers know how to navigate opportunities as they arise throughout the market cycle.

Today’s market environment calls for caution in all types of investment strategies, high-yield bonds included. But reducing high-yield exposure while maintaining concentrated risky exposure elsewhere isn’t the right solution. We think a more diversified strategy is the best bet for maintaining income and reducing drawdown risk.

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 Author

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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