Equity-like returns with lower volatility

Matt Reynolds

Capital Group

Income helps provide a stable source of returns. Capital Group developed the Global High Income Opportunities strategy (GHIO) 20 years ago. Within this strategy, we look to invest in corporate high-yield and emerging market debt, as they usually offer significantly higher yields than developed market sovereign bonds, and the income component has been one of the main drivers of GHIO’s returns.

If the macroeconomic environment proves better than expected, the potential for capital appreciation could allow GHIO to offer equity-like returns, but with lower volatility due to the income component. That said, past results are not a guarantee of future results.

Corporate high yield and emerging market debt are within the higher-yielding part of the fixed income universe. That said, both emerging market local currency debt (as measured by the JPM GBI-EM Global Diversified Index) and emerging market hard currency debt (as measured by the JPM EMBI Global Index) have an average credit rating of investment-grade BBB; whereas US high yield corporate debt (as measured by the Bloomberg Barclays US High Yield Corporate Index) has an average credit rating of BB, below investment grade.

Capital Group’s GHIO strategy was developed with the vision that these higher-returning fixed income asset classes offer similar risk-return profiles, but follow different cycles — so by investing flexibly across those sub-asset classes, we could offer greater diversification and generate consistent returns.

Our approach to generating income and where we add value.

The GHIO was developed with the vision that corporate high-yield and emerging market debt offer similar risk-return profiles but follow different market cycles. By investing flexibly across those asset classes, we could offer greater diversification and possibly generate consistent returns.

Our strategy for managing GHIO focuses on three main areas: investing in credits that we really understand through our own research, measured asset allocation and paying attention to downside risks.

Capital Group’s intensive on-the-ground research is the main source of our investment ideas across all industries and markets and is the foundation of our investment process. Very few managers have the depth and breadth of Capital Group’s integrated emerging-market proprietary research team that encompasses fixed income, equity and private equity*.

We have extensive coverage of the industries within the high-yield universe, complemented by formal integration with our equity analysts. There have been numerous examples where successful investments in our portfolios were generated from non-traditional ideas as a result of joint research trips attended by fixed income, equity and private equity analysts.

Our asset allocation is more dynamic within the sub-asset classes and is based on making relative value decisions between securities. For example, an allocation to CCC-rated bonds will behave differently to BB-rated bonds within high yield; a move from the former to the latter would effectively be similar to a reduction in credit risk exposure.

The rules we follow and why they are important.

Our philosophy is based on keeping things simple — playing to our strengths in credit research, not trying to cover too many asset classes and not relying on a ‘black box’ or dramatic top-down asset allocation.

It is based primarily on long-term, fundamental research, bottom-up security selection and measured asset allocation with a focus on strategic positioning over long-term credit cycles — which are not necessarily synchronised between emerging markets and high-yield corporates.

Where we are currently finding the best opportunities.

We currently find valuations particularly attractive in a range of local currency emerging markets sovereign debt markets. In particular, the currency element represents an attractive medium-term investment opportunity.

The rally in the US dollar in 2018 was predominantly due to higher US real interest rates and stronger macroeconomic momentum than the rest of the world. The wide real interest rate gap between the US and the rest of the world has narrowed in 2019, while the US macro momentum has slowed sharply in recent months.

Based on our proprietary fundamental exchange rate model, we believe that the US dollar is overvalued and ultimately, the US twin deficits will likely cause its external balance to deteriorate, which in turn should lead to a weaker US dollar.

A stable-to-weaker US dollar is a tailwind for investors allocated to EM local currency debt, as the strong carry characteristics serve to generate an attractive level of return.

We do, however, expect EM currencies to strengthen relative to developed market currencies given the underlying fundamental backdrop, combined with the fact that overall exchange rate valuations are at their cheapest levels since the inception of the EM local currency index (see chart).

What we are avoiding.

Given the depth and potential for diversification within both emerging markets and high-yield debt, we generally find attractive opportunities in both categories, regardless of the market environment.

Some pitfalls of the asset class that investors need to be aware of.

Both high-yield corporate debt and emerging market debt are on the riskier side of fixed income, but a research-based, active management of the asset class can help manage this risk.

For example, managers can offset credit risk by taking positions in more senior debt within the capital structure, protect against interest rate risk by choosing shorter-maturity securities, and hedge inflation risk by choosing inflation-linked bonds.

Managers can also manage currency risk in emerging markets by switching to investment-grade US dollar-denominated bonds or maintaining underlying local bond exposure using currency forward contracts to hedge the currency exposure.

Managers can also use cash or near-cash instruments for capital preservation purposes during times of significant decline in global risk appetite (which typically leads to an increase in yields or capital depreciation in asset classes such as emerging market debt and corporate high yield).

Our long-term return expectations.

We do not manage to specific excess return targets, but we estimate that the sources of excess return could be broken down as follows:

· Security selection 55%

· Country/Market 25%

· Currency 10%

· Asset allocation 10% 

Want access to a steady stream of income?

As one of Livewire’s premium partners, Capital Group has committed to educating investors about income investing through this instalment in the Livewire Income Series. To find out more about the income options that Capital Group provides, please click the 'contact' button below.

Live Webinar: 'How to build a bulletproof income portfolio'

Livewire is hosting a free webinar for investors seeking to broaden their knowledge of different income generating assets classes. The webinar will take place on Thursday the 4th of July at 10:30am.

Click on the link below for full details and to reserve your spot.


*The Capital Group companies manage equities through three investment divisions that make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organisation; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups.

1 contributor mentioned

Matt Reynolds
Matt Reynolds
Investment Director
Capital Group

Matt Reynolds is an Investment Director at Capital Group. He has over 20 years of industry experience including head of Australian equities – core at Colonial First State Global Asset Management. He holds a bachelor's degree in Economics from The...

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