How To Stay Afloat In Choppy High-Income Markets by Gershon Distenfeld, Alliance Bernstein
Brexit has made at least one thing certain: markets are in for a stormy summer. Even so, there are steps that investors who rely on fickle global credit markets for income can take to stay afloat.
Britain’s decision to cut ties with the European Union took markets by surprise and hit risky assets hard. European and US corporate bond markets sold off and credit spreads—the extra yield corporates offer over comparable government bonds—widened.
Qualivian Investment Partners Up 30% YTD; Long ORLY Thesis
Qualivian Investment Partners commentary for the second quarter ended July 30, 2020. Q2 2020 hedge fund letters, conferences and more “Short-term investors will accept a 20% gain because they didn’t spend the time to develop the conviction and foresight to see the next 500%.” - Ian Cassell Executive Summary Readers of investment letters fall into Read More
The referendum result also makes it more likely that global central banks will hold rates low for longer as they redouble efforts to fight stubbornly slow growth.
Here’s the thing: volatility and slow growth aren’t bad things for credit markets or income investors. The former provides opportunities to uncover value, while the later should keep interest rates low.
Companies also tend to be more conservative and avoid taking on too much debt during periods of slow growth. That may not be good news for equity valuations but it is for bond prices and creditors. When growth is strong, on the other hand, companies can get carried away with adding leverage, and that rarely ends well. For a recent example, look no further than the recent rise in energy company defaults.
So as long as the global economy avoids recession, income assets are likely to do well. Here are a few things to keep in mind:
- Keep your hands on the wheel.
Volatility creates opportunities. When something like Brexit happens, an initial wave of knee-jerk selling can lead to exaggerated price moves that are out of sync with underlying fundamentals. Managers who build liquidity buffers into a portfolio put themselves in position to snap up bargains before they get bid higher again.
We saw this recently with high-yield energy bonds, which were punished indiscriminately last year when oil prices fell. After the Brexit result, sell-offs in European high-yield debt, select emerging-market (EM) currencies, and corporate bonds issued by European banks and financial firms brought in a wave of eager buyers who picked up these assets at attractive prices.
None of this can be done, though, with a portfolio on autopilot. A hands-on approach gives managers flexibility to ferret out mispriced securities. Tracking an index doesn’t. That’s why even average active high-yield mutual funds routinely beat passive exchange-traded funds.
- Diversify, diversify, diversify.
There are still a lot of crowded trades out there. That’s why we see investors rush out of various sectors every time market turbulence rises. This creates opportunities for those who can take a contrarian view. A global multi-sector approach that diversifies exposure to sectors and regions also diversifies sources of return and income.
In fact, valuations in many high-income sectors, such as EM currencies and debt, are more attractive today than they’ve been in years. In high yield, the compensation investors receive for the risk of default is well above average. This may not last long. If Brexit prompts central banks in Europe, Japan and other slow-growth economies to escalate their quantitative easing programs, as we think it will, the opportunity to lock in these attractive valuations will disappear.
- Pay attention to credit cycles.
Diversification is always important, but it takes on added significance during the late stages of a credit cycle. And that’s exactly where we are in many market sectors today. It’s important to remember that there isn’t just one “credit cycle.” There are multiple ones under way at any given time around the world.
In the past, they were usually closely correlated. But divergent monetary policies and growth rates today mean there’s considerable variation by region. European industrials, for instance, are still in expansion mode, while Latin American corporates are in the repair phase and US financials are in recovery. Cycles also vary by sector, since different industries respond differently to monetary stimulus.
Flexible investors might decide to ratchet down exposure to late-cycle sectors or regions—say, parts of the US high-yield market or European industrials—and increase exposure to sectors where valuations are more attractive, such as US mortgage-related securities.
In the short run, the UK’s referendum result will make for a rougher ride in global markets. But with the right approach, income investors may find that the volatility adds wind to their sails.
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.