Late-cycle markets can unnerve high-income investors. But we see ways to generate a healthy level of income while potentially decreasing overall risk.
When markets are in the later stages of the credit cycle and systemic risks are heightened, investors often do one of the following:
- Some react to slowing growth and low or negative interest rates by stretching for more yield in CCC-rated corporate bonds or other higher-risk, lower-quality assets. And they often do it by investing in concentrated, single-sector strategies that lack diversification.
- Others shy away from return-seeking credit assets altogether, accepting less income in exchange for better protection against large drawdowns.
To our minds, neither approach stands much chance of helping investors reach their goals. The first approach exposes them to too much risk—likely with inadequate compensation—while the second limits income potential and may not provide as much protection as investors expect.
Instead, investors should consider globalizing their high-income strategies and looking for opportunities across fixed-income sectors. This diversifies a portfolio, increasing income potential and reducing downside risk. Both are important because the risk associated with “risk assets”—high-yield bonds, equities, leveraged bank loans and so on—can vary widely.
Take high-yield bonds, a major ingredient in any high-income strategy. Over time, high-yield bond returns have more in common with stock returns than with returns on other types of bonds. But there’s one important difference: high-yield bonds are about half as volatile as equities and offer more downside protection.
This argues not for abandoning high yield late in the credit cycle, but for owning high yield to help reduce downside risk. In fact, by shifting some equity exposure to high yield, investors can de-risk the overall portfolio while only modestly curbing its return potential. We think investors can dampen volatility even further by focusing on shorter-maturity high-yield bonds, which tend to do better when Treasury and credit yield curves are flat, as they are today.
It also helps to take the long view. Volatility comes and goes, but investors who maintain exposure to high-yield debt across market cycles have been rewarded for it. That’s because yield is a remarkably reliable indicator of the total return investors can expect to earn over the next five years. The yield-to-worst of the global high-yield market was 5.7% as of December 31, 2019. That’s a hard figure to ignore in today’s environment of low to negative government bond yields.