Keeping Your Balance as the Credit Cycle Turns

26 June 2023

4 min read

Matthew Sheridan, CFA| Lead Portfolio Manager—Income Strategies

Gershon M. Distenfeld, CFA | Director—Income Strategies

Striking the right balance between interest-rate and credit risk can be a good idea in the late stages of a credit cycle. We think it’s a particularly good idea in this credit cycle.

Why? Consider that over the last 18 months, investors have grappled with the swiftest tightening of global monetary policy in four decades and a banking crisis that claimed three regional US banks. Yet the American economy has so far managed to avoid contraction. Despite a persistently strong labor market, inflation has eased somewhat from its 40-year peak, though it remains high.

The Federal Reserve, meanwhile, says it is committed to pushing inflation back to the central bank’s long-term 2% target, and the longer that takes, the more likely recession becomes. Indeed, while the Fed held policy rates steady this month, it said it expected to raise them again later in the year.

A Bond Strategy for All Weathers

We suspect this will bring us closer to a turn in the US credit cycle. But pinpointing when this might happen—no easy task in the best of circumstances—is especially fraught in today’s market environment. That’s why we think the time is right for income-oriented investors to consider pairing government bonds and other interest-rate sensitive securities with growth-sensitive credit assets in a single, dynamically managed portfolio.

Both types of bonds are good at generating income—particularly now that inflation and tighter monetary policy have helped to drive yields higher. A diversified “barbell” strategy that balances interest-rate and credit risk allows investors to lean one way or the other at any given moment—an approach that we believe can deliver a high level of income with strong downside mitigation.

We think of it as an all-weather strategy, but now may be the ideal time to lift a barbell, particularly if growth slows enough in the coming months to warrant interest-rate cuts in 2024.

Rates and Risk: Moving in Opposite Directions

Credit barbells have traditionally worked because the two major types of bond risk tend to be negatively correlated. Government bonds typically do well when growth slows, inflation cools, and markets start bracing for lower interest rates. That has made them reliable diversifiers of higher-yielding corporate and emerging-market bonds, which like equities, shine brightest when growth is strong and rates are rising.

These relationships broke down in 2022 when the two fell in tandem. Some investors began to question whether the days of negative correlations were over. They weren’t. The relationship, as measured by government bonds and equities, was reestablished earlier this year (Display).

Government Bond, Equity Correlations Turn Negative Again

Return correlations were positive in 2022 but have since returned to negative territory.

Past performance does not guarantee future results.
As of May 31, 2023
Source: Bloomberg, S&P and AllianceBernstein (AB)

Over the longer run, we expect the historical pattern to reassert itself. Correlated selloffs of government bonds and credit assets have been exceedingly rare over the last 30 years. Yet even when the two types of assets do decline in tandem, a barbell strategy may help to minimize the damage. Those who segregate rate-sensitive and credit assets in different portfolios or entrust them to different managers may be tempted in such situations to sell—and lock in losses—in both.

Government Bonds, Credit Rarely Underperform at the Same Time

Over the last 30 years, positive correlation between government debt and credit has been rare.

Historical analyses do not guarantee future results.
HY is represented by Bloomberg US Corporate High Yield. TSY is represented by Bloomberg US Treasury. An investor cannot invest directly in an index and its performance does not reflect the performance of any AB portfolio.
Reflects quarterly returns starting from April 1, 1993 to March 31, 2023. Numbers may not sum due to rounding.
Source: Bloomberg and AB

Walking the Tightrope

What does it all mean for investors today?

To start with, we believe the credit cycle will begin to turn later this year as tighter monetary policy squeezes growth. If a recession starts to look likely, investors will want to maintain liquidity and a healthy dose of duration—a measure of sensitivity to changes in interest-rate levels. Government bonds do an excellent job of providing both.

At the same time, exposure to “spread sectors” such as high-yield bonds, select emerging-market corporate debt and commercial mortgage-backed securities can bring balance to a portfolio and allows managers to increase income potential. But with credit spreads currently below average, we believe it’s important to be especially cautious when it comes to CCC-rated corporate bonds, which would be particularly vulnerable in an economic downturn.

Today’s market conditions are challenging, particularly when compared to the extended low-volatility, low-rate environment that preceded the pandemic. When uncertainty is high, the best thing investors can do, in our view, is keep their powder dry and be prepared for multiple outcomes. We believe a balanced approach to income generation helps them do just that.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Matthew Sheridan, CFA

Matthew Sheridan is a Senior Vice President and Portfolio Manager at AB, primarily focusing on the Income Strategies portfolios. He is a member of the Global Fixed Income, Global High Income and Emerging Market Debt portfolio-management teams. Additionally, Sheridan is a member of the Rates and Currency Research Review team and the Emerging Market Debt Research Review team. He joined AB in 1998 and previously worked in the firm’s Structured Asset Securities Group. Sheridan holds a BS in finance from Syracuse University. He is a CFA charterholder. Location: New York

Gershon M. Distenfeld, CFA

Gershon Distenfeld is a Senior Vice President, Director of Income Strategies and a member of the firm’s Operating Committee. He is responsible for the portfolio management and strategic growth of AB’s income platform with almost $60B in assets under management. This includes the multiple-award-winning Global High Yield and American Income portfolios, flagship fixed-income funds on the firm’s Luxembourg-domiciled fund platform for non-US investors. Distenfeld also oversees AB’s public leveraged finance business. He joined AB in 1998 as a fixed-income business analyst and served in the following roles: high-yield trader (1999–2002), high-yield portfolio manager (2002–2006), director of High Yield (2006–2015), director of Credit (2015–2018) and co-head of Fixed Income (2018–2023). Distenfeld began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. He holds a BS in finance from the Sy Syms School of Business at Yeshiva University and is a CFA charterholder. Location: Nashville

Scott DiMaggio, CFA

Scott DiMaggio is a Senior Vice President, Head of Fixed Income and a member of the Operating Committee. As Head of Fixed Income, he is responsible for the management and strategic growth of AB’s fixed-income business and investment decisions across the department. DiMaggio has previously served as director of Global Fixed Income and continues to be a portfolio manager across numerous multi-sector and multi-currency strategies. Prior to joining AB’s Fixed Income portfolio-management team, he performed quantitative investment analysis, including asset-liability, asset-allocation, return attribution and risk analysis for the firm. Before joining the firm in 1999, DiMaggio was a risk management market analyst at Santander Investment Securities. He also held positions as a senior consultant at Ernst & Young and Andersen Consulting. DiMaggio holds a BS in business administration from the State University of New York, Albany, and an MS in finance from Baruch College. He is a member of the Global Association of Risk Professionals and a CFA charterholder. Location: New York

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Keeping Your Balance as the Credit Cycle Turns

A Bond Strategy for All Weathers

Rates and Risk: Moving in Opposite Directions

Walking the Tightrope

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