As 2018 approaches, investors may want to take some time to reexamine their high-income strategies. We’ve got some advice: Be selective. Be diversified. And, perhaps most importantly, be patient.
If you’re an income-conscious investor, abandoning a high-income strategy isn’t an option. But simply setting a course and sticking with it, irrespective of changing conditions and valuations, can lead to trouble. That’s especially true at a time when yields are low and fixed-income assets look expensive.
In situations like these, patience really is a virtue. Investors should resist the urge to reach for yield, and concentrate on maximizing opportunity and reducing risk. A global, multi-sector strategy can provide access to multiple sources of income and return.
But it’s also important to take a broad sector-by-sector approach to the market, followed by a deeper dive into individual securities. This can help investors identify and avoid areas of the market where risk appears to exceed potential return.
Here are a few things to think about as the new year nears:
Get into a European State of Mind
High-yield corporates are an important component of any high-income strategy. But valuations are high on both sides of the Atlantic, so investors have to pick their spots carefully. In particular, we see value in subordinated European financial bonds. These bonds offer attractive yields to compensate investors for the risk they’re taking by buying a bond that’s further down the capital structure. But we think a stricter regulatory environment significantly reduces the probability that these types of securities will default on their obligations.
Contrast that with US high-yield bank loans. One of the reasons they’ve been in high demand is their senior position in the capital structure; if a borrower defaults, loan investors usually get more principal back than bond investors. But more than half of loan issuers today have no unsecured bond debt cushioning their balance sheets (Display). That means no cushion for loan investors should these companies run into trouble. Being subordinate in European high yield looks more attractive than being senior in US bank loans.
Finally, European high yield may be especially attractive to US-dollar–based investors, who hedge the currency exposure back to the dollar. This is because short-term rates in the US are much higher than in the euro. By hedging back to dollars, an investor can pick up more than 200 basis points in yield.