Join Kevin Johnson, CFA, head of Platform Distribution, and Christopher Lee, CFA, senior portfolio manager on the Plus Fixed Income team, as they discuss the current market environment and how adding short duration income to a portfolio may help investors find consistency through inconsistent markets.
Christopher Lee: Choosing investments that offer resiliency and consistency through a wide variety of market environments can make a very big difference in the outcome over long periods of time.
Kevin Johnson: That’s Christopher Lee, senior portfolio manager of U.S. High Yield for Allspring Global Investments. I’m Kevin Johnson, head of Platform Distribution here at Allspring, and you’re listening to On the Trading Desk®. Today, we’re discussing how compounding income can help investors build resiliency into their portfolios. Thanks for being here, Chris.
Christopher: Happy to be here, Kevin. Thanks for having me.
Kevin: Okay, Chris. Just to get started, certainly over the last 20 years or so, investors have been challenged to navigate a wide variety of risk environments, including the great financial crisis of 2008/2009, and certainly, most recently, the COVID-19 pandemic. How would you describe today’s markets and do you believe a new risk-off period is approaching?
Christopher: Cyclical periods of volatility and euphoria, of course, are inherent in markets. Over the past 20 years, investors have confronted the great financial crisis, the COVID-19 crisis, growth scares in 2016 and 2018, and other market events that have led to wider credit spreads and equity drawdowns. In between those sharp risk-off periods, investors have enjoyed relatively extended recovery periods, which allow patient investors the opportunity to generate attractive long-term total returns through steady income and the power of compounded growth. And for the better part of the past year, investors have faced elevated rate and spread volatility, stemming from the rapid interest rate increases in the macro-economic uncertainty that those interest rate increases bring. I think what’s unique about today’s corporate bond landscape is that yield curves are very flat. Among BB-rated corporate bonds, both 1-to 3-year and 7-to-10-year parts of the corporate yield curve, they both yield around 7%. Normally, investors demand greater return for the uncertainty of investing over a longer time horizon. For example, four years ago, investors demanded well over 100 basis points to extend from that front end of the curve to the long end of the BB corporate credit curve. And it’s quite intuitive that investors demand more yield for a longer maturity since predicting a corporate financial’s wherewithal over a longer period entails greater uncertainty than over a shorter period.
Kevin: What advice would you give to help investors navigate today’s markets and build resiliency into their portfolio?
Christopher: Consider the role 1-to-3-year corporate BB bonds play in a broadly diversified portfolio, particularly since you can earn the same yield in the front end of the BB corporate curve today that you can in the long end, and just take advantage of a market condition that doesn’t happen very often. A short-term high yield strategy targets corporate bonds on the front end of the curve and at the higher end of the non-investment grade credit rating spectrum.
Kevin: You shared the importance of compounding income in a portfolio. Can we go a bit deeper on this subject? How should investors think about duration and credit exposures when allocating to fixed income?
Christopher: We recently published a white paper, entitled Compounding Income Can Build Resiliency. Now that white paper examined the impact that the income stream of a short-term high-income strategy has a diversified fixed income portfolio. That’s 60% invested in the Agg (The Bloomberg U.S. Aggregate Bond Index) and 40% invested in a short-term high-income strategy. We found that over the past 20 years a portfolio consisting of 60% Agg and 40% short-term high-income provided less volatility and a smoother ride than either of the individual components alone. This is because a short-term high-income strategy experienced relatively few periods of negative total returns. And when it does experience those periods of negative total return, the volatility is short lived, and the duration of the Agg component stabilizes the returns. It’s important to understand that the reason a short-term high-income strategy’s volatility has been short lived in past times of market distress is because of our focus on the front end of the yield curve and the upper end of the non-investment grade rating spectrum. These bonds are the most liquid among high yield bonds and when selected appropriately have clear paths toward refinancing, which makes their prices less volatile. Ensuring that a short maturity high yield bond has multiple paths to refinancing entails a great deal of diligence. One must forecast cash flows, analyze competitive threats and understand bond indenture covenants, among many other factors. And in my opinion, this is really where an active manager can shine. Now returning to the topic of how a 60% Agg, 40% short-term high-income strategy provides diversification benefits. In periods where duration underperforms, spreads typically outperform, right?
Kevin: Yeah.
Christopher: In other words, spreads are cyclical and duration is counter-cyclical. A short-term high-income strategy provides spread or additional income compared to the Agg and that additional income compounds over time.
Kevin: Okay. How should investors put those thoughts into action?
Christopher: It’s interesting, Kevin. The most common question that we receive from investors is, should I invest in high yield now? And I really think that the better question is, how can I build portfolio resiliency? And the answer is pairing a duration sensitive fixed income strategy with a short-term high-income strategy both reduces overall portfolio volatility while adding income. And we ultimately believe this is a much better solution for most investors than attempting to time entry and exit points into and out of the high yield market.
Kevin: With the time we have left, do you have any parting thoughts for our listeners?
Christopher: Sure. So, investors regularly confront the unknown and markets are ever-changing and certainly very difficult to predict.
Kevin: Yeah.
Christopher: Choosing investments that offer resiliency and consistency through a wide variety of market environments can make a very big difference in the outcome investors ultimately achieve over long periods of time. A short-term high-income strategy provides investors an opportunity to compound real income while keeping volatility at lower levels. And this has allowed investors to benefit throughout the market cycle.
Kevin: All right. Thank you, Chris. And thank you for being here today and sharing your insights.
Christopher: Kevin, it was my pleasure. And thanks again for having me.
Kevin: And for our listeners, thank you for joining us here On the Trading Desk®.
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Disclosure: CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. The ratings indicated are from Standard & Poor’s, Moody’s Investors Service, and/or Fitch Ratings Ltd. Credit-quality ratings: Credit-quality ratings apply to underlying holdings of the fund and not the fund itself. Standard & Poor’s rates the creditworthiness of bonds from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody’s rates the creditworthiness of bonds from AAA (highest) to C (lowest). Ratings Aa to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories. Fitch rates the creditworthiness of bonds from AAA (highest) to D (lowest). 100 basis points equals 1.00%. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The Bloomberg U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S.-dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities. You cannot invest directly in an index.
