Two Approaches to Managing Volatility in High Yield
These are uncertain times in markets, and that creates a dilemma for investors who need high levels of income but can’t stomach a high level of risk. We have a solution. Actually, we have two.
Investors who need income know it’s impossible to avoid risk altogether. And with global growth gaining traction and the Trump administration pushing deregulation, tax cuts and infrastructure spending, maintaining exposure to high-yielding “risk” assets makes sense.
Even so, there are plenty of things that could upend the current growth trajectory and provoke market turbulence. Antiestablishment parties could win upcoming French and German elections. Or President Trump could double-down on his immigration and trade policies—or simply spook markets with his rhetoric.
In other words, investors shouldn’t expect uninterrupted tranquility this year. That can be unsettling for investors because high-income investments such as high-yield corporate bonds or emerging market assets are usually the first to sell off when volatility spikes.
Yet pulling out of high-income sectors entirely isn’t an option for most investors, particularly when income is so hard to come by. Fortunately, staying exposed and limiting your risk aren’t mutually exclusive.
The key is finding a way to understand and manage the two major risks that bond investors face: interest-rate risk and credit risk. There are two paths investors can take.
LIMIT DURATION—AND PRIORITIZE QUALITY
First, investors can shorten duration and focus on quality. Over time, high-quality, short-duration bonds have dampened portfolio volatility and held up better in down markets.
Duration is a measure of a bond’s sensitivity to changes in its yield. In general, bonds are highly sensitive to yield changes—when yields rise, prices fall. The shorter the duration, the less damage a rise in yields will do.
That’s important, because valuations in many parts of the high-yield market are stretched today, so there’s plenty of room for yields to rise. Average yields declined sharply last year and credit spreads—the extra yield that high-yield bonds offer over comparable government bonds—are hovering around their lowest level in more than two years. If faster-than-expected inflation obliges the Fed to quicken the pace of interest-rate hikes this year, that could slow economic growth. In that case, high-yield spreads could rise in a hurry.
But a short-duration strategy by itself isn’t enough. That’s because the primary risk for short-duration high-yield bonds is credit risk. And with many parts of the high-yield market in the later stages of the credit cycle, avoiding low-quality, CCC-rated “junk” bonds is critically important.