Stressed? A Low Volatility Strategy May Help by Gershon Distenfeld & Ivan Rudolph-Shabinsky

Investing means taking calculated risks, but nobody should have to lose sleep over it. If your portfolio is keeping you up nights, it may be time to consider a low-volatility strategy.

No matter what country they call home, investors who need their portfolios to generate steady income know they have to take some risk to get returns. But markets have grown more volatile and less predictable this year, and high-income assets are usually the first to sell off when sentiment sours or the market outlook changes.

Yet pulling out of high-income sectors altogether isn’t an option for most of us—particularly when income is so hard to come by. So how can investors stay the course and generate the income they need without taking undue risk?

Our research shows that high-quality, short-duration bonds have over time dampened portfolio volatility and held up better in down markets.

What’s the secret? A lot of it has to do with duration, a measure of a bond’s sensitivity to changes in its yield. In general, bonds are highly sensitive to yield changes—when yields rise, prices fall. The shorter the duration, the less damage a rise in yields will do.

For most investment-grade bonds, yield changes are driven primarily by changes to interest rates, or the yields on government bonds. High-yield bonds, though, are less sensitive to interest-rate changes than other types of bonds. But yields can rise for a number of reasons. When concern about global growth and falling commodity prices hit high-yield bond markets hard earlier this year, the shorter-duration bonds held up best.

Like any strategy, a short-duration one can lose money in down markets—but it generally loses much less than strategies with higher duration and additional risk.

Riding The Asset-Allocation Seesaw

In up markets, on the other hand, investors who follow a short-duration strategy give up some return in exchange for a smoother ride—but not as much as they might think. To understand why, it can help to think of one’s various investment options as an asset-allocation seesaw, with cash in the middle; interest-rate sensitive assets, which do well in “risk-off” environments, on the left; and return-seeking assets, which thrive when investor risk appetite is high, on the right (Display 1).

Low Volatility Strategy, Asset-Allocation, High Yield

Low Volatility Strategy

Moving away from cash in either direction increases return. On the rate-sensitive side, moving away from the center increases duration, but investors are compensated with higher yields. There’s a catch, though: yields rise on a curve, not a straight line, so the further out one moves, the smaller the yield increase. Moving from cash to three-year government bonds can provide a hefty bump in yield. But the pickup available when moving from 10-year to 30-year bonds can be tiny.

It’s a similar story on the return-seeking side: return expectations increase as one moves away from cash, but by ever diminishing amounts. Moving from high-yield bonds to equity, for instance, increases returns only slightly, but doubles drawdown risk.

The good news is that this works when moving toward the center, too. An investor who wants to reduce risk doesn’t have to go all the way to cash. For example, she can shorten duration by moving from high yield to low-volatility high yield and only give up a little return in the process.

Don’t Skimp On Quality

Of course, not all high-yielding securities are alike. Credit quality varies widely, and that’s particularly important in short-duration strategies. The primary risk for short-duration high-yield bonds is credit risk.

We’re in the late stages of the credit cycle in many parts of the global high-yield market. Reaching for the high yields on low-quality, CCC-rated “junk bonds” in that environment is dangerous. In our view, the yields don’t justify the relatively high risk of default.

How investors choose to balance returns, risk and downside protection will vary depending on individual needs and comfort levels. But in our view, the ability to reduce risk and not sacrifice too much return makes this strategy a compelling one in today’s volatile markets. At the very least, we think it could help investors rest easier at night.

This article previously appeared in Institutional Investor.

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.