To implement relatively defensive positioning while still generating yield, we focus on areas with the potential to better withstand a resumption in volatility. We favor allocations to shorter-duration bonds in some sectors with credit risk with structurally attractive risk/return profiles.
In order to implement relatively defensive portfolio positioning while still generating yield, we are focusing on certain areas of the market that have the potential to better withstand a resumption in volatility. We favor allocations to shorter-duration bonds in some sectors with credit risk with structurally attractive risk/return profiles. These includes asset-backed securities and dollar-denominated emerging markets debt.
When analyzing sectors, we look at the amount of widening in credit spreads that would offset the extra income generated from those spreads over the course of one year—this is the break-even threshold. Then we compare the standard deviation of credit spreads to the break-even level to gauge the likelihood that they will exceed the break-even threshold.
For example, in short-term emerging market corporate debt, our analysis shows that the recent one-year standard deviation of spreads is 29 basis points. Because this is less than the break-even level, it provides a cushion until the break-even level is reached if we experience the same level of spread volatility that we did over the past 12 months. In contrast, for the broad U.S. investment-grade corporate sector, the standard deviation of spreads exceeds the break-even threshold.
We are carefully watching for signals that could change our outlook. If the economy unexpectedly slides into a recession, the short duration of our positions will limit exposure to credit risk. On the other hand, if stronger-than expected economic
numbers push the Fed off the sidelines to raise rates, an additional advantage of exposure to shorter-duration credit sectors is their lower price sensitivity to interest rate increases.