Stressed? A Low-Volatility Strategy May Help

Investors who are feeling a bit risk averse these days could try a high-yield, low-volatility bond strategy.

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

No matter which 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 at AllianceBernstein shows that high-quality, short-duration bonds have dampened portfolio volatility over time and have 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 are other types of bonds. Keep in mind, however, that 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 short-duration bonds held up best.

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

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On the other hand, investors who follow a short-duration strategy in up markets forgo some return in exchange for a smoother ride — but not as much as they might think. To understand why, it can be helpful 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 (see chart).

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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 high yields. There’s a catch, though: Yields rise on a curve, not a straight line, so the further out one moves, the smaller the increase in yield. Moving from cash to three-year government bonds can provide a hefty bump in yield. But the pickup available when moving from ten-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 increases returns only slightly and yet doubles drawdown risk.

The good news is that this also works when moving toward the center. Investors who want to reduce risk don’t have to go all the way to cash: They can shorten duration by moving from a full high-yield to low-volatility, high-yield and only give up a little return in the process.

Of course, not all high-yielding securities are alike. Credit quality varies widely. 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 such an 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. We think, however, that 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.

Gershon Distenfeld is director of high-yield debt, and Ivan Rudolph-Shabinsky is portfolio manager–credit; both at AB in New York.

See AB’s disclaimer.

Get more on fixed income.

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