It’s easy to get spooked in late-cycle markets. But we think there’s a way to de-risk your portfolio and still generate a decent level of income—no magic spells necessary.

Investors often do one of the following things when markets are in the later stages of the credit cycle:

• Some react to slower growth and falling interest rates by stretching for more yield in CCC-rated corporate bonds, preferred stocks 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.

The way we see it, neither approach stands much chance of helping investors reach their goals. The first exposes them to too much risk—likely with inadequate compensation—while the second is bound to limit income potential and may not reduce risk by as much as people think.

What’s the alternative? Simple: globalize your high-income strategy and look for opportunities across fixed-income sectors. This diversifies a portfolio, which increases income potential and reduces downside risk. Both are important because the risk associated with “risk assets”—high-yield bonds, equities, leveraged bank loans and so on—varies considerably.

Not All Risk Assets Perform Equally

Put another way, some risk assets are riskier than others. Take high-yield bonds, a building block of any high-income strategy. Over time, high-yield performance has more in common with stocks than other types of bonds, but with one important difference: it’s about half as volatile.

As Display 1 shows, global high-yield returns were not far below those from the MSCI World Index of global stocks over the past decade. And they comfortably outpaced what a 60/40 stock-bond portfolio delivered. But high yield offered more downside protection and was less volatile than either one, giving it a higher risk/return ratio.

Here’s another way to think about this: investors who consider high yield too risky to own late in the cycle should be even more frightened of owning equities. Now, we’re not suggesting that they abandon either one; both belong in a diversified investment portfolio.

But by shifting some equity exposure to high yield, investors can end up lowering portfolio risk while only modestly curbing return potential. We think investors can dampen volatility even further by focusing on shorter-maturity high-yield bonds, which tend to do better when the US Treasury and credit yield curves are flat, as they are today.

The worst thing investors can do, in our view, when the outlook darkens and volatility spikes is to trade all their high-yield exposure (and their equities, for that matter) for investment-grade corporate debt and high-quality government bonds. In today’s low-yield world, this can make it very tough to produce the income so many investors need.

We think it helps here 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. This is because the yield you start with is a remarkably good indicator of what you can expect to earn over the next five years. Today’s yield-to-worst for the broad global high-yield market—the lowest likely return you should get—is nearly 6.2%. That’s a hard number to ignore when the 10-year US Treasury yield sits at just 1.75% and comparable Japanese and German yields are well below zero.

Go Global

Of course, active security selection is as important in the high-yield market today as it is anywhere else. We think a global lens can help.

For instance, we see select opportunities in European high-yield bonds, which are broadly higher in quality than their US counterparts. This is especially so for US dollar–based investors, who can boost returns by hedging back to the higher rate of the US currency (Display 2).

We see value in subordinated European financial bonds, which offer attractive yields to compensate investors for the risk they’re taking by buying a bond that’s further down the capital structure. These securities also benefit from solid banking-sector fundamentals

Diversify Your Portfolio, Dispel Your Fears

The next step to a more sustainable high-income strategy, as we see it, is to add other return-seeking assets to the mix. As Display 3 illustrates, many offer more attractive combinations of yield and quality today than high-yield bonds do.

US residential and commercial mortgage-backed securities have proved more resilient than other credit assets to trade tensions and other geopolitical risk. The former benefit from a solid US housing market, while the latter have been driven down in price due to what we consider an excessively gloomy outlook for US shopping malls that back some of the loans. Both offer a healthy yield pickup over similarly rated corporate debt.

Valuations are also broadly attractive in emerging-market debt, which offers a significant yield pickup over developed-market bonds. What’s more, inflation is low in most emerging economies, providing room for central banks to cut rates, and economic fundamentals are solid.

We’re living in a world of low yields and high volatility—and we don’t expect that to change soon. This is a frightening thought, we know. But investing in single-sector income strategies or abandoning high-income assets entirely can be even scarier, especially in an uncertain, late-cycle environment. In our view, a global high-income strategy diversified across sectors is most likely to offer strong return potential and downside protection.

Gershon Distenfeld is Co-Head—Fixed Income; Director—Credit

Noelle Chiang is Director and Senior Investment Strategist—Fixed Income

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 and are subject to revision over time.