Introducing a Low-Volatility Factor to High-Yield Fixed Income
For your clients seeking income, today’s environment is a tricky one. Interest rates are climbing, fixed-income yields are still low, and equities are at higher levels than they’ve ever been.
Volatility, of course, can be a killer for anyone, but that’s particularly so for investors who are past the accumulation stage and are forced to draw down on principal for their income needs. As an advisor, that presents a sizable challenge: how can you lower risk and continue to provide an attractive yield—all within a relatively short time horizon? One answer: rebalance your client portfolios using a low-volatility strategy in the high-yield fixed income space.
Low-volatility investing is nothing new. It’s been a popular approach in the equities space for years, and there’s been solid evidence—empirically and academically—that it works well as a risk-reduction tool. But despite the success that this low-volatility approach was bringing to many investors, the strategy was largely ignored in high-yield fixed income. Why? Though the proximity of high-yield corporate bonds to equities was the logical next step, making that leap meant overcoming some significant barriers, not the least of which was figuring how to determine the volatility of bonds in the first place. Unlike equities, fixed income instruments don’t trade every day, so calculating volatility by measuring the standard deviation of price changes is difficult (to say the least). Another challenge was that, as bonds age, their duration shortens, which decreases the volatility. Credit ratings add even more complexity to the puzzle. While ratings do offer some level of information, they’re generally subjective and, as such, may be less reliable. Worse yet, these ratings simply aren’t updated frequently enough to account for recent events. After all, you need to know it’s time to get out of a bond before a credit downgrade and the spread starts widening, not after the fact!
Luckily, statisticians came to the rescue more than 15 years ago with the standard DTS calculation. DTS multiplies a bond’s duration (D) times (T) its credit spread (S) to measure a bond’s riskiness. DTS is important because it allows bonds to be ranked not by their less-than-reliable credit risk scores, but instead by a volatility risk score that reflects real time market data. Today, in an environment where the credit spread has dipped from 8.5% down to 3.3% and there may be little additional opportunity for contraction in the high-yield fixed income space, identifying high yield, low volatility bonds is essential. DTS is the tool to do just that.
After seeing how valuable DTS can be when it comes to selecting low-volatility bonds, we took the process one step further. To gain even greater portfolio benefits, we began comparing each bond to the portfolio’s weighted average DTS and identifying each bond’s marginal contribution to risk (MCR). Looking at the S&P 500 High Yield Corporate Bond Index, this calculation is used to rank bonds from lowest to highest according to each one’s marginal contribution to risk within the portfolio. Using that ranking, it’s then simple to identify the least risky bonds; we just divide the index in half, and then select the bonds that are ranked in the lower half. Filtering for the most liquid high yield and then rebalancing no more than monthly can also help uncover that all-important sweet spot between yield, liquidity, turnover costs (which should always be considered), and risk.
Of course, by leveraging lower-risk bonds, it’s inevitable that some opportunity for higher yield will be lost. But in today’s low interest rate environment, high yield remains one of the last remaining bastions for income. In fact, high yield bonds have the highest yield per unit of risk when compared to all other income producing asset classes. For retirees and others that are generally concerned about the current level of credit spreads, this ability to lower volatility while continuing to attract high yield can help achieve one of this group’s most important goals: generating income while preserving assets. Give these clients a way to slow down and reduce risk, and you just may help them win the race.
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IndexIQ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.
Top Picks in Asset Allocation
Written b: John Bilton, Head of Global Multi-Asset Strategy, Multi-Asset Solutions
As global growth broadens out and the reflation theme gains traction, the outlook brightens for risky assets
Four times a year, our Multi-Asset Solutions team holds a two-day-long Strategy Summit where senior portfolio managers and strategists discuss the economic and market outlook. After a rigorous examination of a wide range of quantitative and qualitative measures and some spirited debate, the team establishes key themes and determines its current views on asset allocation. Those views will be reflected across multi-asset portfolios managed by the team.
From our most recent summit, held in early March, here are key themes and their macro and asset class implications:
Key themes and their implications
Asset allocation views
For the first time in seven years, we see growing evidence that we may get a more familiar end to this business cycle. After feeling our way through a brave new world of negative rates and “lower for longer,” we’re dusting off the late-cycle playbook and familiarizing ourselves once again with the old normal. That is not to say that we see an imminent lurch toward the tail end of the cycle and the inevitable events that follow. Crucially, with growth broadening out and policy tightening only glacially, we see a gradual transition to late cycle and a steady rise in yields that, recent price action suggests, should not scare the horses in the equity markets.
If it all sounds a bit too Goldilocks, it’s worth reflecting that, in the end, this is what policymakers are paid to deliver. While there are persistent event risks in Europe and the policies of the Trump administration remain rather fluid, the underlying pace of economic growth is reassuring and the trajectory of U.S. rate hikes is relatively accommodative by any reasonable measure. So even if stock markets, which have performed robustly so far this year, are perhaps due a pause, our conviction is firming that risk asset markets can continue to deliver throughout 2017.
Economic data so far this year have surprised to the upside in both their level and their breadth. Forward-looking indicators suggest that this period of trend-like global growth can persist through 2017, and risks are more skewed to the upside. The U.S. economy’s mid-cycle phase will likely morph toward late cycle during the year, but there are few signs yet of the late-cycle exuberance that tends to precede a recession. This is keeping the Federal Reserve (Fed) rather restrained, and with three rate hikes on the cards for this year and three more in 2018, it remains plausible that this cycle could set records for its length.
Our asset allocation reflects a growing confidence that economic momentum will broaden out further over the year. We increase conviction in our equity overweight (OW), and while equities may be due a period of consolidation, we see stock markets performing well over 2017. We remain OW U.S. and emerging market equity, and increase our OW to Japanese stocks, which have attractive earnings momentum; we also upgrade Asia Pacific ex-Japan equity to OW given the better data from China. European equity, while cheap, is exposed to risks around the French election, so for now we keep our neutral stance. UK stocks are our sole underweight (UW), as we expect support from the weak pound to be increasingly dominated by the economic challenges of Brexit. On balance, diversification broadly across regions is our favored way to reflect an equity OW in today’s more upbeat global environment.
With Fed hikes on the horizon, we are hardening our UW stance on duration, but, to be clear, we think that fears of a sharp rise in yields are wide of the mark. Instead, a grind higher in global yields, roughly in line with forwards, reasonably reflects the gradually shifting policy environment. In these circumstances, we expect credit to outperform duration, and although high valuations across credit markets are prompting a greater tone of caution, we maintain our OW to credit.
For the U.S. dollar, the offsetting forces of rising U.S. rates and better global growth probably leave the greenback range-bound. Event risks in Europe could see the dollar rise modestly in the short term, but repeating the sharp and broad-based rally of 2014-15 looks unlikely. A more stable dollar and trend-like global growth create a benign backdrop for emerging markets and commodities alike, leading us to close our EM debt UW and maintain a neutral on the commodity complex.
Our portfolio reflects a world of better growth that is progressing toward later cycle. The biggest threats to this would be a sharp rise in the dollar or a political crisis in Europe, while a further increase in corporate confidence or bigger-than-expected fiscal stimulus are upside risks. As we move toward a more “normal” late-cycle phase than we dared hope for a year back, fears over excessive policy tightening snuffing out the cycle will grow. But after several years of coaxing the economy back to health, the Fed, in its current form, will be nothing if not measured..
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This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be a recommendation for any specific investment product, strategy, plan feature or other purpose. Any examples used are generic, hypothetical and for illustration purposes only. Prior to making any investment or financial decisions, an investor should seek individualized advice from a personal financial, legal, tax and other professional advisors that take into account all of the particular facts and circumstances of an investor’s own situation.
J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co and its affiliates worldwide. Copyright 2017 JPMorgan Chase & Co. All rights reserved.
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