Introducing a Low-Volatility Factor to High-Yield Fixed Income

For your clients seeking income, today’s environment is a tricky one. Interest rates are climbing, fixed-income yields are still low, and equities are at higher levels than they’ve ever been.

Volatility, of course, can be a killer for anyone, but that’s particularly so for investors who are past the accumulation stage and are forced to draw down on principal for their income needs. As an advisor, that presents a sizable challenge: how can you lower risk and continue to provide an attractive yield—all within a relatively short time horizon? One answer: rebalance your client portfolios using a low-volatility strategy in the high-yield fixed income space.

Low-volatility investing is nothing new. It’s been a popular approach in the equities space for years, and there’s been solid evidence—empirically and academically—that it works well as a risk-reduction tool. But despite the success that this low-volatility approach was bringing to many investors, the strategy was largely ignored in high-yield fixed income. Why? Though the proximity of high-yield corporate bonds to equities was the logical next step, making that leap meant overcoming some significant barriers, not the least of which was figuring how to determine the volatility of bonds in the first place. Unlike equities, fixed income instruments don’t trade every day, so calculating volatility by measuring the standard deviation of price changes is difficult (to say the least). Another challenge was that, as bonds age, their duration shortens, which decreases the volatility. Credit ratings add even more complexity to the puzzle. While ratings do offer some level of information, they’re generally subjective and, as such, may be less reliable. Worse yet, these ratings simply aren’t updated frequently enough to account for recent events. After all, you need to know it’s time to get out of a bond before a credit downgrade and the spread starts widening, not after the fact!

Luckily, statisticians came to the rescue more than 15 years ago with the standard DTS calculation. DTS multiplies a bond’s duration (D) times (T) its credit spread (S) to measure a bond’s riskiness. DTS is important because it allows bonds to be ranked not by their less-than-reliable credit risk scores, but instead by a volatility risk score that reflects real time market data. Today, in an environment where the credit spread has dipped from 8.5% down to 3.3% and there may be little additional opportunity for contraction in the high-yield fixed income space, identifying high yield, low volatility bonds is essential. DTS is the tool to do just that.

After seeing how valuable DTS can be when it comes to selecting low-volatility bonds, we took the process one step further. To gain even greater portfolio benefits, we began comparing each bond to the portfolio’s weighted average DTS and identifying each bond’s marginal contribution to risk (MCR). Looking at the S&P 500 High Yield Corporate Bond Index, this calculation is used to rank bonds from lowest to highest according to each one’s marginal contribution to risk within the portfolio. Using that ranking, it’s then simple to identify the least risky bonds; we just divide the index in half, and then select the bonds that are ranked in the lower half. Filtering for the most liquid high yield and then rebalancing no more than monthly can also help uncover that all-important sweet spot between yield, liquidity, turnover costs (which should always be considered), and risk.

Of course, by leveraging lower-risk bonds, it’s inevitable that some opportunity for higher yield will be lost. But in today’s low interest rate environment, high yield remains one of the last remaining bastions for income. In fact, high yield bonds have the highest yield per unit of risk when compared to all other income producing asset classes. For retirees and others that are generally concerned about the current level of credit spreads, this ability to lower volatility while continuing to attract high yield can help achieve one of this group’s most important goals: generating income while preserving assets. Give these clients a way to slow down and reduce risk, and you just may help them win the race.

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IndexIQ®is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.