As economic cycles enter their later stages, investors sometimes find that they’re taking too much risk to generate income. There’s a strategy that can help—and we think now is the time to use it.
Pairing high-yield corporate bonds and other credit assets with high-quality government debt in a dynamic “barbell” strategy has been a good way to generate income while limiting downside risk. This is mainly because the return streams tend to be negatively correlated; one does well when the other struggles, and a manager can alter the weightings as valuations and conditions change.
A barbell approach can work at any time in a market cycle, but we think conditions today are especially ideal for it—in particular for investors who want to limit their downside risk without giving up too much income. Here are three reasons to lift a barbell today:
1. You’re not being paid to take all that credit risk. Most credit assets are expensive today. Take the US high-yield market. The average yield spread—the extra yield over comparable government bonds—has hovered recently around 3.80%. That’s well below the long-run average of 5.07%.
This should be a concern for investors who reduced duration—a measure of interest-rate sensitivity—when interest rates were rising and over-allocated to credit. That was a common strategy in 2018 as the US Federal Reserve delivered four interest-rate increases and economic growth was strong.
Here’s the problem: both actions reduce the defensive nature of a bond portfolio in a risk-off environment. Investors learned that at the end of last year, when markets began to fear the Fed had tightened policy too much and credit and other risk assets sold off.
We now know the fourth-quarter downturn was a correction, not the start of a prolonged risk-off environment. But at 10 years and counting, the US credit cycle is one of the longest on record. At some point, the expansionary period will end and the downturn phase will begin. We’re not quite there yet. But we think we’re getting closer—and so, it seems, does the Fed, which last week reduced its US growth forecast and signaled that it was unlikely to raise rates again this year.