In the current market environment, with increased volatility roiling the waters, many investors, understandably spooked, are moving out of high yield bonds into short duration fixed income, emerging market bonds and equities. I am not going to tell you that moving out of high yield is either definitively right or wrong. In fact, I avoid such pronouncements for what I consider a very sound reason: What is right for one investor–given his or her portfolio, risk tolerance, liquidity and distribution needs and time horizon-is not necessarily right for another investor.
That said, I would caution against simply shunning high yield altogether in knee-jerk fashion just because others are doing so. Admittedly, high yield is not cheap right now–no more so than equities, in fact. However, depending on your current portfolio allocation, the investment moves you have made in recent years and your estimation of where the market is headed, high yield can play a particularly important role in a diversified portfolio today.
Let’s say you are an investor worried about market volatility, but you nonetheless have a positive view on the economy and corporate profits. You are also aware that, over the last three years, many investors (perhaps you’re one of them) have become overextended in equities. Now there are suddenly headwinds because cautious investors are not increasing equity allocations at the same pace they formerly were. As a result, your equity exposure may feel a lot longer and riskier than it did a few years ago. Owning high yield, however, allows you to de-risk your portfolio while still maintaining exposure to the upside of corporate profits.
If you think equities will return 20% in the near term (something I would not bet on in the ninth year of an economic expansion), you may want to sell all your credit. However, if you think there are serious headwinds (as I believe there are) in the form of de-risking, rebalancing and deceleration – and you consider that valuations and volatility have doubled of late – it’s reasonable to believe equities will return somewhere between -10% to 10%. If so, you could replace your equity holdings with credit. That’s because if equities are at 5%, high yield could also easily be at 5%, giving you the same return with less risk. However, in an environment where equities are down 10%, credit could be flat.
Regardless of the scenario, high yield remains a good way to remain tied to profit growth, lower your equity exposure, decrease your volatility and still get mid-single-digit returns. With credits you are buying downside protection, you have moved up the capital structure, and if they default you have protection.
I’m not pounding the table saying that now is the best time to buy high yield, but I am saying this is how it can fit in a diversified portfolio – even if you are generally bullish on equities. If you are constructively bearish, you may want to instead consider bank loans. And if you’re completely bearish, you shouldn’t own a dime of equities; in fact, you should own 10-year treasuries.
At the end of the day, it’s not about being right or wrong. As the market starts to get clipped, dispersion increases, policy becomes less accommodative, and you aren’t crazy if you think we aren’t headed to the moon. For investors who share that view, de-risking part of your portfolio out of equities into high yield is a sound strategy.
Article was originally on BlackRock.com
© 2018 BlackRock, Inc. All rights reserved.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2018, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. Commodities’ prices may be highly volatile. Prices may be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the prices of precious metals. Concentrated investments in specific industries, sectors, markets or asset classes may under-perform or be more volatile than other industries, sectors, markets or asset classes and the general securities market. A significant portion of the aggregate world gold holdings is owned by governments, central banks and related institutions. One or more of these institutions could sell in amounts large enough to cause a decline in world gold prices. Should there be an increase in the level of hedge activity of gold producing companies, it could cause a decline in world gold prices. Should the speculative community take a negative view towards gold, it could cause a decline in world gold prices. You cannot invest directly in an index.
©2018 BlackRock, Inc. All Rights Reserved. BLACKROCK is a registered trademark of BlackRock, Inc. All other trademarks are those of their respective owners.