Positioning credit investments in portfolios
When deciding the amount and types of credit sectors to include in a portfolio, investors should distinguish between strategic, longer-term allocations and more tactical, shorter-term positioning. Regardless of time horizon, we think investors would benefit from working with active managers who have proven track records in risk management when determining these allocations, particularly in the late stages of the credit cycle.
Strategic allocation view
The amount of credit exposure to hold within a strategic fixed income allocation depends on an investor’s intended long-term outcome. For growth investors, the fixed income allocation should provide attractive risk-adjusted returns over time and diversify the overall equity risk of the portfolio.
Diversified credit sectors such as high yield bonds, leveraged loans, preferred securities and emerging markets debt have shown to diversify core bonds and improve risk-adjusted returns over various time periods (see Figure 7). For most growth investors, we believe that the appropriate allocation to a diversified basket of credit sectors falls somewhere in the range of 15-30% of the total fixed income allocation. The remaining fixed income should be allocated to core fixed income strategies, which are designed to diversify equity risk and mitigate portfolio volatility.
Income investors should place higher emphasis on the current income a portfolio can generate, typically measured by current yields. We think investors should consider increasing their allocation to diversified credit sectors to meet their income goals, but to do so cautiously given that the higher allocation to certain credit sectors may increase portfolio sensitivity to equity market swings.
Tactical allocation view
Over the next six to 12 months, we see more attractive risk-adjusted return prospects from taxable investment grade credit than from U.S. high yield bonds, as late cycle dynamics may create increased price volatility in lower-quality sectors. With regard to leveraged loans, we expect the U.S. Treasury yield curve to remain flat, or even bull steepen (where short rates fall more than long rates) if the Fed reverses course and decides to cut rates in 2019.7 If this plays out, it may create a ceiling on leveraged loan demand.
Shifting from low- to high-quality fixed income would mean that investors would be accepting lower yields in an effort to better protect principal. For income investors who wish to maintain higher yield levels, we suggest over-weighting emerging markets debt, given that higher credit quality than U.S. speculative grade credit, attractive valuations, and (in our view) a U.S. dollar stabilized by accommodating monetary policy could create tailwinds for the remainder of 2019. For income investors comfortable with added U.S. equity market volatility, allocating to preferred securities is another way to increase credit quality, but without sacrificing as much yield when compared to investing in investment grade corporate bonds. For tax-sensitive income investors, we continue to see value in longer-dated municipals as well, including high yield municipals, which remain attractive based on AAA/U.S. Treasury yield ratios and favorable supply/demand dynamics.
Putting it all together
Following are our summary views for how investors may want to consider constructing portfolios in the latter stages of the credit cycle:
- We believe the current economic cycle still has room to run, and see no evidence that we will see a near-term end to the credit cycle.
- As such, our fixed income portfolio managers see select opportunities in diversified credit sectors such as leveraged loans, preferred securities and emerging market debt.
- Above all, retain a focus on research-based active management, which has the flexibility and nimbleness to seek out opportunities across sectors, credit qualities and geographies.