Investment Strategies for Generating Efficient Income

02 May 2022
4 Minute Read

What You Need to Know

An unfriendly macro and market landscape is making life harder for investors today, with traditional core bonds coming up short on income. In our view, focusing on generating efficient income is an effective approach to tackling the challenge of mixing the key building blocks of rates, credit and growth.

-51%
maximum drawdown for high-dividend stocks since January 1, 2012
77%
of three-year rolling periods since 2001 that global multisector credit outperformed US high yield.
1.06 vs. 0.49
Sharpe ratio advantage of credit barbell versus US Treasuries from January 2012 through December 31, 2021
Authors

An Unfriendly Landscape for Income Investors

A challenging macro mix is set to make investing a lot more challenging in the years ahead: The share of the world’s population that’s of working age seems to have peaked. Growth in world trade, a huge economic tailwind since the mid- 1980s, has flattened. And the global debt burden is nearing 140% of gross domestic product (GDP)—it’s well documented that levels above 100% can create economic headwinds.

Collectively, these factors will likely yield lower growth and higher inflation, creating a challenging environment for investors. The challenge is particularly acute for income-seeking investors: high-quality bonds, the traditional cornerstone of income-oriented portfolios, can no longer provide a meaningful amount of income.

Traditional Core Bonds Are Coming Up Short on Income

Feeling the income pinch with traditional high-quality core bonds, many investors have gravitated to other sources, including bank loans, high-yield bonds and high-dividend equities. These assets offer higher yields, but they’re also a lot riskier than core bonds (Display).

Equity beta tells the tale, and helps show how equity-like an asset is. Core bonds, with a modestly positive equity beta, aren’t equity-like at all. Bank loan, high-yield bond and high-dividend equity betas range from 0.29 to 0.84. With higher beta comes the risk of bigger losses: bigger losses: the maximum drawdown for core bonds has been –7.6% historically, for bank loans –30.1%, for high-yield bonds –33.2% and for high-dividend equities 51.1%. These tumbles usually happen when the stock market is also falling, magnifying the damage to portfolios.

Higher-Yielding Alternatives Come With More Market Risk
US Treasury yields alongside equity betas and drawdown risks for various asset classes.

Current analysis and past performance do not guarantee future results.
10-year US Treasury yield from January 1, 1982 to March 31, 2022. Beta and average drawdown are calculated from January 1, 2012 through January 31, 2022; max drawdown is calculated from January 1, 2012 through December 31, 2021. Core bonds, bank loans, high-yield bonds and high-dividend equities are represented by the Bloomberg US Aggregate Bond Index, S&P/LSTA Leveraged Loan Index, ICE BofA US High Yield Index and MSCI USA High Dividend Yield Index, respectively.
As of January 1, 2022. Source: Bloomberg, ICE Data Indices, Morningstar Direct, MSCI, S&P, US Federal Reserve and AllianceBernstein (AB)

If income investors can no longer look to core bonds for their income needs, how can they access more income without taking on too much risk? The key is to build efficient income portfolios, getting the most income and total return for each added unit of risk taken on. Investors can also view the challenge through a different risk lens—seeking to minimize the drawdown risk of a portfolio at any income level.

Efficient Income Building Blocks: Rates, Credit and Growth

We think income investors should refine their portfolios based on a diversified mix of three building blocks: rates, credit and growth. Each plays a key role in designing an appropriate income formula, as we can see from a few traditional examples.

The rates building block, represented by the Bloomberg US Aggregate Bond Index, has shown its ability to counterbalance risk-asset losses, posting a positive return of more than 8% in bear markets. Credit, illustrated by US high yield, has a superior yield of 5.79% and the growth building block, the S&P 500 Index, outpaces the other two building blocks in long-term growth potential.

While these examples help illustrate the value of each block, in practice, there’s a lot more investors can do to refine each building block—and combine them in effective ways that are tailored to their specific income and risk preferences.

Past performance, historical and current analyses, and expectations do not guarantee future results.

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.


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