Want High Income? Time To Expand Your Horizons by Gershon Distenfeld, AllianceBernstein

As we look ahead to 2016, we still see attractive opportunities for investors who need their portfolios to deliver a high level of income. CCC-rated corporate bonds are not one of them.

We’ve spent a lot of time this year urging investors to avoid CCCs because the rewards seem too meager to justify the risk. These securities are the riskiest in the high-yield bond market and have a higher chance of defaulting than do other bonds.

Sure, the yields are enticing. But with the credit cycle in its final stages and the Federal Reserve preparing to lift interest rates, it’s a bad time to load up on CCCs. As borrowing costs rise, some highly levered companies may struggle to raise capital, putting their ability to pay their creditors at risk.

Here’s a quick look at some alternative investments and strategies that we consider likely to deliver better risk-adjusted returns.

  1. Keep volatility low by targeting B- and BB-rated bonds. In high yield, we see better value in B- and BB-rated bonds. Though these bonds have lower yields than do CCCs, they’re also less likely to default. That’s important now that we’re in the later stages of the credit cycle.

Investors can focus on higher-quality bonds by investing in a low-volatility high-yield portfolio, which typically excludes CCCs. Yes, excluding CCCs will lower overall yield. But investors can make up for this by slightly increasing the share of their portfolios dedicated to high yield.

For example, an investor who normally dedicates 10% of her portfolio to high yield might want to increase that amount to 13% when investing in a low-volatility portfolio. In our view, this increase has the potential to boost risk-adjusted returns. Oh, and by the way, BB-rated bonds are up 1% so far this year. CCCs? They’re down about 9%.

  1. Diversify by going global. Because the US high-yield market is the biggest, it often gets the most attention. But it’s important to remember that there are corporate bond markets beyond US borders—and some of them offer attractive opportunities. That’s especially true in Europe, which is in an earlier stage of the credit cycle. Companies have delevered and are growing more confident as the economy rebounds. As always, it’s critical to do your credit homework before you invest.
  2. Don’t ignore emerging markets—but be selective. This year has been a rough one for emerging-market (EM) assets, and many investors are understandably skittish. But those looking to boost income shouldn’t write off emerging markets altogether. Because when it comes to corporate bonds, EM risk is often mispriced.

As my colleague Shamaila Kahn points out, many EM companies are becoming more global and moving into developed markets. Even so, EM bonds tend to have lower credit ratings and higher yields than those issued by their developed-market counterparts. As a result, some EM bonds may be attractive from a risk/reward perspective. Of course, selectivity is vitally important. Make sure your investment manager has both a global perspective and the ability to dive deeply into individual companies to find value.

  1. Take a closer look at distressed mortgages. Mortgages are different from corporate bonds. The CCC label on corporates indicates there’s a relatively high probability of default—and of the bond not repaying the investor at par, or face value. CCC-rated mortgage securities, on the other hand, are already trading at a hefty discount—for example, an investor might buy one at $75 (par is $100)—and our research shows investors are more likely to recoup that initial investment. Plus, there’s more upside potential.

We appreciate that 2015 has been a volatile and challenging year for investors. We expect volatility to remain elevated in the year ahead. But with the right approach, that doesn’t have to mean lower returns.

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.

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