Looking for a tactical way to de-risk your portfolio? You might consider rotating a portion of your equity allocation into high-yield bonds.
Yes, you read that right. It may take a minute to process, since buying high yield is usually thought of as a way to add risk. And with risk assets—notably stocks and high yield—bearing the brunt of the recent market sell-off, adding risk is the last thing many investors want to do right now.
Here’s what you may not realize: when combined with stocks, high yield can reduce overall risk without sacrificing much return. In fact, high yield and equities together can actually boost risk-adjusted return potential (Display 1).
Income That’s High and Consistent
How is this possible?
To start with, high-yield bonds provide investors with a consistent income stream that few other assets can match. This income—distributed semiannually as coupon payments—is constant. It gets paid in bull markets and bear markets alike. After accounting for maturities, tenders and callable bonds, the high-yield market typically returns anywhere from 18% to 22% of its value every year in cash.
Along with these payments, high-yield bonds also have a known terminal value that investors can count on. As long as the issuer doesn’t go bankrupt, investors get their money back when the bond matures.
All of this helps to offset stocks’ higher level of volatility—and provide better downside protection in bear markets. Average calendar year returns for the S&P 500 Index and the Barclays US High-Yield Index were comparable between 1998 and 2015 (7.5% versus 7.3%). But the average drawdown for stocks over that period was 11.8%, nearly twice high-yield’s tally of 6.3%.
Taking Advantage of Wider Spreads
A more typical approach to moderating equity volatility is to reallocate assets to more stable options such as investment-grade bonds, or even cash. But this can exact a heavy cost in sacrificed return potential—especially now that high-yield spreads (the extra yield the bonds offer over comparable Treasury debt) are at their widest in more than four years.
When we measured 12-month rolling returns between 1994—the first year Barclays provided data on option-adjusted spreads—and 2015, we found that high yield outperformed equities when spreads were wide. But how wide is wide enough to justify using high yield as a replacement for equity exposure?
In our view, it can be helpful to establish a decision rule. We conducted a hypothetical exercise in which we set 525 basis points as the spread threshold—if average spreads moved above this level for two straight months, we sold equities and bought high yield.
For simplicity’s sake, we conducted the experiment as if we were shifting entirely out of equities and into high yield. In reality, investors would probably rotate a certain percentage of their equity exposure into high yield.
A hypothetical investor who put $10,000 in the S&P 500 on Jan. 1, 1994 and stuck to this approach for the next 22 years would have made just nine trades—the most recent of which would have been to sell stocks and buy high yield on October 1, 2015. Display 2 illustrates how the rebalanced portfolio would have stacked up against the respective indices. The hypothetical returns assume the assets were fully invested over the entire time period and do not include transaction costs or taxes.
Recovering Losses Quickly
Some of high yield’s advantage comes down to valuations. At current spreads, high-yield bonds are more attractively valued than they’ve been in years.
Of course, it’s still critical to choose your exposures carefully. It’s late in the credit cycle and default rates will likely rise this year. The valuations on many energy, metals and mining bonds, as well as other CCC-rated debt with fragile finances, don’t look so compelling.
But select higher-quality, BB-rated debt looks more attractive. If volatility eases and spreads start to tighten, that will boost potential returns. If they widen further, investors can take comfort knowing that high yield tends to make up its losses more quickly than stocks do.
The high-yield market has suffered 11 peak-to-trough losses of greater than 5% in the last 25 years. On average, investors recovered their losses in about six months—and sometimes as few as two.
We doubt the market turbulence we experienced in 2015 will disappear this year. For investors who want to tamp down the volatility in their equity portfolios without giving up on the return potential that stocks offer, a dash of high-yield debt may be the answer.
This article previously appeared in Barron’s.
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.