Reaching For Yield? Be Aware Of What Lies Beneath...

Jeff unpacks what the markets are saying about a growth slowdown, and why investors should take a closer look at their bond allocations.

Three quarters into 2019, stock and bond performance seems to be telling a story of relative calm. Scratch the surface, however, and underlying market movements complicate the narrative. In particular, a trend toward quality suggests that investors are more concerned than they first appear.

Beneath the market calm… A focus on quality

While volatility has only recently increased, the move to quality - in both stocks and bonds - has been occurring for some time, and is consistent with late-economic-cycle crowding by investors into "safer" assets. The metrics bear it out in the graph below.

The equity metric, shown in yellow, charts the relative performance of low-default-risk companies versus those with a high risk of default in the Russell 1000 Index. The upward sloping line shows how high-quality companies are outperforming their lower-quality counterparts.

The second metric, in orange, charts the difference in yield, or spread, between high-yield bonds in the Bloomberg Barclays US High Yield Index at two different risk levels: B-rated and, one notch down, CCC-rated. Once again, the upward sloping line indicates that slightly higher quality (and less risky) bonds are outperforming.

A tale of two impulses

What's immediately apparent are the general performance similarities between bond and equity markets. The relative strength of the equity-based measure may reflect a degree of investor crowding into more defensive positions.

For bonds, the less dramatic out-performance in higher quality names may reflect a more complex story: investor fears about recession risk may be tempered by a continued need for yield. In other words, bond investors are seeking less exposure to companies that may be adversely affected by the economic cycle. Yet the current state of rate policy, which is preemptively pushing rates lower, also motivates them to reach for yield. That has kept the overall level of spreads low even as investors ditch more risky bonds.

A baby step, to be sure but still a step.

The consequences of reaching for yield…

With these signs of rising recession risk clear, we pivot to some portfolio construction consequences for investors.

The long-standing dilemma for portfolios is that prolonged periods of zero and negative interest rates have resulted in decreased availability of bond income.

In eras prior to the financial crisis, yields on higher-quality assets such as Treasuries and investment-grade bonds generally offered sufficient income, even after adjusting for inflation. These assets also offered diversification from equity risk as their prices reliably rose in periods of equity declines.

That changed, of course, post crisis, when the collapse in yields meant that investors had to choose between the "safety" of government bonds or higher income and face the consequences of greater risk.

The graph below highlights a stylized measurement of these trade-offs. As investors get more aggressive and allocate to higher percentages of risky yield sources (such as high-yield bonds, emerging market debt and bank loans), it comes at the cost of less diversification, in the form of higher correlation, or "beta," to equities.

…is less ballast from bonds

Importantly, the graph also shows how the trade-off becomes more exaggerated during equity market selloffs. In this case, we examine how the correlation of a fixed income allocation increases during S&P 500 declines greater than 2% in a single month.

It is in these periods that investors will need the diversification of fixed income most. Yet, as fixed-income portfolios add riskier assets, they may also compromise its ability to act as ballast against equity downturns.

That brings us back to today. We highlight these trade-offs not because they are new: they aren't. But in an environment where several signs point toward rising recession risks, the role of bond diversification takes on heightened importance.

It's not yet clear that investors are getting the message. Instead of being misled by the calm surface of market performance, they need to understand the risks of overreaching for yield and look to true diversifiers in case the cycle takes a turn for the worse.

This post originally appeared on the BlackRock Blog.

Editor's Note

: The summary bullets for this article were chosen by Seeking Alpha editors.