President Trump came to office with the expectations of faster economic growth on the back of infrastructure spending, deregulation and tax cuts. His first 100 days in office have shown – once again – that delivering is more difficult than promising. Against a backdrop of gently rising interest rates and solid economic growth, the US corporate bond market still provides relatively attractive returns. But, given the possibility of periodic volatility, investors need to be selective and flexible says Gershon Distenfeld, Director of High Yield at AllianceBernstein:
Solid economic growth and a possible extension of the current US credit cycle, if President Trump delivers on some of his campaign policies, present a clear case for exposure to higher-yielding US assets. Credit cycles are a normal feature of markets, and have distinct stages. As the US credit cycle enters its ninth year, fundamentals have shown signs of some deterioration. But the run-up in prices for high-yield bonds, equities and other “risk” assets suggests that markets are betting that the current cycle has longer to run. And this optimism is reflected in positive survey data since Trump’s election.
It seems to us that many investors are pricing in all the potential positives associated with a Trump administration—such as infrastructure spending or tax reform—and none of the potential downside risks, for example trade protectionism and political dysfunction. As a result, the prices of some higher-yielding US assets have become expensive, requiring investors to be selective.
There are plenty of things that could upset the growth trajectory. For a start, Trump could continue to face challenges getting his policies through Congress. Alternatively, growth could come under pressure if he were to double-down on trade policies that might hurt growth in the long term. There’s also the strong possibility that positive survey data is overly optimistic and expectations will come down from their current elevated levels.
Investors looking for attractive returns in the US shouldn’t expect uninterrupted tranquillity ahead. That can be unsettling for because high-income investments such as high-yield corporate bonds or emerging market assets are usually the first to sell off when volatility spikes.
Fortunately, getting exposure and limiting your risk aren’t mutually exclusive.
The key is finding a way to understand and manage the potential risks: there are several paths bond investors can take.
Emphasize higher-rated securities from companies with strong balance sheets. They’re better positioned to weather higher borrowing costs and investment outflows than issuers of CCC-rated “junk” bonds. Even with solid economic growth, higher interest rates could push some CCC-rated issuers toward default.
Consider shorter maturity bonds. Our research has found that, over time, high quality, shorter-maturity bonds capture about 80% of upside moves in the high-yield market, but only about 70% of downside ones. Shorter maturities mean investors are less exposed to the impact of higher interest rates and just about any type of market hiccup. So they tend to hold up better when markets turn volatile.
Pair high-yield credit with high-quality government bonds. Interest-rate sensitive US Treasuries and other high-quality government bond, tend to perform well when growth slows. High-yielding credit assets, on the other hand, usually shine when economic growth accelerates and interest rates rise.
Combining these into a balanced barbell approach can help a bond portfolio weather most market environments. A hypothetical 50-50 blend of the US 10-year Treasury and the Bloomberg Barclays US High-Yield Corporate Bond Index would over the past 16 years have delivered better risk-adjusted returns than portfolios invested solely in Treasuries, investment-grade corporate bonds or high yield.
Another good source of diversification and income comes from US securitized assets. Credit risk transfer securities (CRTs) from the US government housing agencies Fannie Mae and Freddie Mac allow investors to tap into a strong US housing market. CRT’s floating rates make them especially appealing as US interest rates rise.
As President Trump passes his 100-day milestone and continues to face the realities of being in office, it’s important to take action to limit portfolio volatility should markets get messy without giving up altogether on your income goals generated by investments in the world’s largest economy.
Gershon Distenfeld, Director of High-Yield Debt, beim Asset Manager AB