In high yield specifically, investors tend to think about it as a risky way to play fixed income. But we like to turn that thinking on its head, actually: that you should think about it as a way to de-risk your overall portfolio rather than to re-risk your fixed-income side.
If you look historically, investors tend to lean very heavily into the traditional 60/40 portfolio. And that works well, because as your stock portfolio does poorly, generally your government bonds do pretty well. There’s that negative correlation benefit that helps in your portfolio construction.
But if you actually take out a percentage of your equity exposure and move that into high yield—so rather than take your government bond exposure down, take exposure out of the risky part of your portfolio into high yield—just like stocks, it actually has a negative correlation to Treasury rates.
A traditional 60/40 portfolio generates somewhere about 8.7% annualized returns over the last few decades. If you take 15% out of stocks and put it into traditional high yield, your returns drop, but only to about 8.2%. But the very interesting thing is that your risk and drawdowns improve measurably. Your Sharpe ratio is about 10% better, and your drawdown as a worst-case scenario is about 5% better than the traditional 60/40.
And that’s what we would really recommend that clients focus on in their portfolios today is, firstly, diversification across a lot of different assets. So, if there is an issue in one, it doesn’t cause you too much pain.
And secondly is to really try to dive deeper into “what’s my potential return versus that downside risk.” In high yield specifically, starting yield to worst is something that our market talks about all the time. And if you take starting yield to worst and put a 2% band around it, so 2% higher, 2% lower, what’s the chance that your one-year returns end up within that band versus your starting yield. The results might surprise you.
Only about 20% of the time since 1994 do your one-year returns end up within that band. 40% of the time, it ends up being lower than the lower part of your band, and 40% of the time, it ends up being higher than the higher part of your band. Yield to worst is actually a very bad predictor of what’s going to happen to your investment over the next one year. You have to really extend out to almost five years for that starting yield to worst to be a good predictor of what your annualized returns will be.
When we think about the potential returns in, say, emerging markets or securitized assets or European or Asian credit, we use this same sort of framework, where that starting yield or that starting valuation can give you a pretty good sense of what your returns are over the next three to five years. Again, not a good predictor over the next one year.
We think including emerging markets when you’re looking for income is a very sensible thing to do. Firstly, because it offers you very good diversification benefits versus developed market corporates. In general, emerging markets pay you a higher level of yield above and beyond what you can earn in developed-market corporates.
Part of the reason why is because, just like corporates, the vast majority of emerging-market countries pay you back. Sometimes a country or two will default as we’ve seen over history, but they tend to be very idiosyncratic in nature. One of the hallmarks that we think of fixed-income investing is trying to diversify that risk. Don’t just lend to one country in one particular region, but instead, look at the entire opportunity set and diversify away a lot of that idiosyncratic style risk.
We think investors, in summary, should really look at high-yield investing as a way to de-risk their equity portfolio rather than to take more rate risk. And in today’s environment, we think that’s warranted, given how well a lot of asset classes have already performed to really try to focus on the risk side of your portfolio, reduce that risk, and move into a higher-income producing asset class.
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 change over time.
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