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De-Risking with High Yield in
Today’s Volatile Market

James Keenan, CFA |Jul 16, 2018

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, 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 previously 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. 

Bottom line: 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 increased 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 return 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 and policy becomes less accommodative, you may be concerned that 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.