Balancing Risks as the Credit Cycle Turns

Balancing credit risk with interest-rate risk in a dynamically managed portfolio can be an all-weather approach.

Central banks across the US, UK and Europe have shifted to an easing phase, signaling a change in the credit cycle. The chances of a soft landing for the global economy look promising, in our view. Yet the downside risks could be high; geopolitical conflicts, record peace-time debt burdens and the lingering aftermath of COVID make for an exceptionally unpredictable backdrop.

Hence, risk-aware bond investors need portfolio strategies that can both capture opportunities and cope with periods of high volatility and sudden drawdowns. We think it’s timely to consider a dynamic barbell approach that combines defensive high-quality bonds with higher-yielding credits.

Playing Too Safe Wastes Opportunities

A traditional investment-grade multi-sector bond portfolio offers clear attractions: low default risk combined with a modest yield pickup over Treasuries in a readily understood package. Even so, this approach comes with an opportunity cost. An investment-grade-only portfolio misses out on the benefit of wider diversification, which creates the opportunity to manage risk more efficiently and potentially achieve higher income and better risk-adjusted returns.

Taking the US as an example, a simple 50/50 passive “barbell” combination of US Treasuries with US high-yield bonds rated BB or B has historically produced better outcomes than both BBB-rated US corporate bonds and the broader US Aggregate Index across a range of metrics. These include higher income, lower volatility, less interest-rate risk (duration), and higher risk-adjusted returns (Display)—features that have characterized the barbell approach over time.

Data for euro and global markets over the same time frame show similar patterns: higher income and risk-adjusted returns, with mostly lower duration and comparable volatility.

Combine Negatively Correlated Assets

A credit barbell combines interest-rate-sensitive bonds with higher-yielding credit assets because their returns are usually negatively correlated. When riskier, growth-oriented credit assets such as high-yield bonds fall in value, government bonds and other interest-rate-sensitive assets usually rise, and vice versa. Because negatively correlated assets tend to take turns outperforming each other, investors can sell the outperformers on one side (for instance, high-quality high yield) and buy the cheaper bonds on the other (for example, Treasuries). That approach has historically tended to increase returns over time.

In our 50/50 barbell example, we used US Treasuries to represent interest-rate risk and US high yield as a proxy for credit risk. The investment-grade portfolio underperformed this barbell because it lacked enough exposure to credit risk to generate higher income and returns. Credit risk is typically well compensated with income. Using option-adjusted spread divided by volatility as a measure of income per unit of risk, we can see that US high yield is a very efficient income generator (Display).

Both global and euro data show similar rankings to the US, with high yield clearly the most efficient income generator.

The income contribution from high yield is critical. Historically, the biggest component of bond returns has come from income payouts to bondholders rather than capital appreciation. In fact, over the last 20 years, US high-yield bonds’ annual return due to income has slightly exceeded annual total return. Hence, a strategy that is underexposed to income per unit of risk will likely struggle to generate attractive returns for risk-conscious investors.

Aim for the Right Balance

What’s the right mix of assets? That depends on each investor’s needs and comfort level. A simple 50/50 split could be right for an investor with high income requirements and a high risk tolerance, because credit assets are at least twice as volatile as high-quality government debt. So when it comes to risk exposure, an even split between the two asset classes effectively tilts toward credit.

An investor who wants a more balanced exposure would likely incline toward a 65% Treasuries / 35% high-yield allocation, giving up a small amount of return in exchange for lower risk. In practice, investors seeking an optimal mix would also likely allocate to a wide variety of higher-yielding fixed-income sectors, including not only high-yield bonds but also corporate and hard-currency emerging-market debt, inflation-linked bonds and securitized assets.

Most important, we believe keeping the right balance involves an active, dynamic approach that explicitly manages the interplay of rate and credit risks. To that end, credit barbells offer an advantage: combining diversifying assets in a single portfolio makes it easier to manage risk and tilt toward duration or credit according to market conditions.

Choose Horses for Courses as Economies Diverge

The challenges facing the world’s three biggest economic drivers—the US, Europe and China—have become increasingly diverse. As a result, we expect rate paths and risk-asset valuations to continue to diverge as well. This divergence creates opportunities for investors and particularly for dynamic barbell approaches, in our view. 

In the eurozone, for instance, we think pockets of the high-yield markets appear especially attractive, while segments of the European government bond markets look reasonably priced to us, considering their defensive characteristics. If growth disappoints or markets turn down, the European Central Bank (ECB) has plenty of scope for deeper rate cuts than the market expects, in our analysis. By contrast, the US economy looks stronger, and the Fed is less likely to cut rates as fast or deep, in our view.

We think high-yield credit remains an attractive component of a barbell strategy for several reasons, even though spreads are currently tight. These include both current advantages (such as compellingly high yields and robust fundamentals), and structural performance benefits resulting from the mechanics of upgrades to and downgrades from investment grade. 

Across global markets, however, low-quality CCC-rated securities account for the bulk of defaults; steering clear of these bonds might make sense when economic conditions are getting tougher. This approach would concede a small amount of return in exchange for significantly lower default risk.

Active Management Can Add Value

There’s no one way to build a well-diversified portfolio. But it’s important to vet potential managers carefully to learn about their investment process and approach to balancing interest-rate and credit risks. Knowing which way to lean—and when—requires a deep understanding of the interest-rate and credit cycles around the world and how they interact. 

We think a portfolio that dynamically balances high-quality and high-income bonds has the potential to weather most markets and represents a more efficient approach than a stand-alone investment-grade multi-sector mandate. In an unstable world, it’s important to keep your balance.