In high yield in particular, investors tend to view it as a risky way to gamble on fixed income securities. But we like to reverse that idea, in fact: that you should think of it as a way to reduce the risk of your overall portfolio rather than re-risking your bond side.

If you look historically, investors tend to lean very heavily on the traditional 60/40 portfolio. And it works well, because because your stock portfolio is doing poorly, your government bonds are generally doing pretty well. There is this negative correlation benefit that helps in building your portfolio.

But if you actually take a percentage of your exposure to equities and shift it towards high yield – then rather than reducing your exposure to government bonds, shift the exposure from the risky part of your portfolio upwards. yield – just like stocks, this actually has a negative correlation with Treasury rates.

A traditional 60/40 portfolio has generated around 8.7% annualized returns over the past several decades. If you take 15% out of the stocks and put them in the traditional high yield, your returns drop, but only to around 8.2%. But what is very interesting is that your risk and your losses improve in a measurable way. Your Sharpe Ratio is around 10% better and your worst-case drawdown is around 5% better than the traditional 60/40.

And that’s what we really recommend clients to focus on in their portfolios today is, first of all, diversification across many different assets. So if there is a problem in one, it doesn’t cause you too much pain.

And second, it’s really trying to dive deeper into “what’s my potential return versus this downside risk”. In high yield in particular, the beginning of the worst return is something our market talks about all the time. And if you take the worst starting yield and put a band of 2% around, so 2% higher, 2% lower, what is the probability that your one-year returns will end up in that band relative to your return? departure. The results might surprise you.

Only about 20% of the time since 1994 have your one-year returns been in this band. 40% of the time it ends up being lower than the lower part of your group, and 40% of the time it ends up being higher than the upper part of your group. The worst-case return is actually a very poor indicator of what will happen to your investment over the next year. You really have to span almost five years for that initial worst-case return to be a good predictor of what your annualized returns will be.

When we think about potential returns, for example, emerging markets or securitized assets or European or Asian credit, we use that same kind of framework, where that starting return or that starting valuation can give you a pretty good idea of ​​where to go. your returns. over the next three to five years. Again, this is not a good predictor over the next year or so.

We believe that including emerging markets when seeking income is a very smart thing to do. First, because it offers you very good diversification advantages over companies in developed markets. In general, emerging markets provide you with a higher level of return than you can earn in companies in developed markets.

This is partly due to the fact that, like businesses, the vast majority of emerging countries reimburse you. Sometimes one or two countries will be lacking, as we have seen throughout history, but they tend to be very idiosyncratic in nature. One of the features we think of in fixed income investing is trying to diversify that risk. Don’t just lend to one country in a particular region, but rather look at the array of opportunities and diversify a lot of that idiosyncratic style risk.

We believe investors, in summary, should really look at high yield investing as a way to reduce the risk of their equity portfolio rather than taking on more rate risk. And in the current environment, we think this is warranted, given the performance of many asset classes to really try to focus on the risk side of your portfolio, reduce that risk, and move to an asset class that produces higher income.