Bond Investors Should Watch Out for the Flavor of the Month by Ashish Shah, AllianceBernstein
Rising rates and inflation aren’t the biggest risks high-yield bond investors face today. We think the larger concerns are concentration and crowding stemming from low liquidity.
Investors are worried that big asset-management firms taking large positions in credit sectors are a danger to the broader financial system. The fear is that a sudden loss or reduction of market liquidity could destabilize the market. In our view, the best defense isn’t exactly new: make sure you’re properly diversified.
Many investors get the basics of that concept already—at least in terms of individual issuers. They know there’s danger in concentrating too much in one bond issuer, because of the risk of default. But there’s a different concentration dynamic going on in today’s market.
The Crowding Craze Has Intensified
The challenge we’re seeing now isn’t overconcentration in a single security, but in a single-focus, flavor-of-the-month product. This could be anything from a US high-yield fund to a European high-yield fund or an emerging-market fund.
When a lot of investors get very enthusiastic or very anxious about a sector, it creates crowding. Some people get good deals and others get trampled. Why is this intensified in today’s market? Individual investors make up a much larger part of the market in specialized asset classes today than in the past. Take US high yield, for example: 25% of the sector’s flows are from individuals, which magnifies the crowding effect. And it leads to more volatility than is justified by fundamentals.
To reduce the impact of the herd, we think bond investors should focus on a multi-sector strategy that diversifies across sectors, geographies and credit quality—and, of course, issuers. Consider analyzing at the security level rather than looking at the sector as a whole. Think objectively about the market and be leery of the “most popular” sectors.
The Love/Hate Affair with Emerging Markets
Here’s an example. Three years ago, people loved emerging markets; 18 months ago, everyone suddenly got worried. When the crowd was pouring in, we didn’t see as much value as others did. We saw risk rising, especially the risk created by everyone buying in.
Then, as retail investors began selling, emerging-market BBB-rated bonds were actually cheaper than corporate high-yield B-rated bonds, which made no sense to us. It happened because high yield was in favor and emerging markets weren’t. Today, after all the in and out movement, emerging markets are a relatively attractive sector with some fundamental opportunities.
More Buckets Are Better
By looking at opportunities globally across asset classes, we think there’s a better chance of finding companies likely to pay you back—and to compensate you for the downside risk you take. This argues for a strategy that has a broad opportunity set. If you need water, running around with your bucket trying to catch the biggest raindrops may seem efficient, but it’s a tough path. A diversified strategy uses more than one bucket to catch more rain.
Investors should also diversify their high-yield bond portfolios to reduce overconcentration in a single manager. Too much money with one manager can increase the risk of that particular manager losing the popularity contest and suffering outflows.
Liquidity has been more prominent on our radar for more than four years—a result of new regulations that began pushing liquidity lower. For many investors, it popped up more recently when manager changes made the concentration problem front-page news. We think diversifying your investments in new ways can help in navigating today’s headline risks.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Ashish Shah is Director of Global Credit at AllianceBernstein Holding LP (NYSE:AB).