Fixed-Income Outlook: The View from Higher Elevations

02 October 2023

5 min read

Gershon M. Distenfeld, CFA | Director—Income Strategies

Good news for bond investors: yields are likely to stay higher for longer. We share strategies for making the most of this environment.

Dovish hikes? Hawkish pauses? Fixed-income investors are struggling to make sense of today’s economic landscape—and many remain reluctant to return to the bond market less than a year after it experienced its worst-ever annual returns. Recent volatility has only added to investors’ concerns. So why, in our view, do these same conditions signal a good entry point for fixed-income investors?

Rates to Stay Higher for Longer, Not Forever

Central banks were in the spotlight in September: the European Central Bank raised rates for what is likely the last time in this cycle; the Bank of England stood pat after 14 consecutive hikes; and the Federal Reserve paused, while simultaneously erasing two projected rate cuts in 2024 from its closely watched “dot plot.”

Despite compelling evidence that central banks have likely completed or nearly completed their hiking cycles, yields have continued to rise globally and are now at cyclical highs. We think this is due in part to market technicals such as increased Treasury supply and in part to policy guidance—that is, it may be some time before central banks reverse their steps and begin to ease. Thus, policy rates—and bond yields—are likely to stay higher for longer.

But higher for longer does not mean higher forever. In our view, yields will eventually trend lower as economic growth slows. Any combination of factors—continued deceleration in inflation, slowing labor markets, a lingering auto strike—could bring economies to heel, driving down yields and boosting bond prices. In the meantime, elevated yields are good for bond investors, since over time most of a bond’s return comes from its yield.

Credit Conditions Call for Cautious Optimism

Of course, sustained higher interest rates are also likely to lead, eventually, to a turn in the credit cycle. Rate hikes are already weighing on activity in many sectors. Households have nearly depleted savings accumulated during the pandemic. Leverage is creeping higher. And interest coverage—the ratio of a company’s EBITDA to its total interest payments—has begun to decline.

But because corporate fundamentals started from a position of historic strength (Display), we’re not expecting a tsunami of corporate defaults and downgrades. In fact, we believe that both government bonds and credit-sensitive sectors have a role to play in portfolios today.

High Interest Coverage May Help Cushion the Impact of Higher Rates

Bloomberg US Corporate High-Yield Index: Interest Coverage (EBITDA/Interest) (×)

At nearly 6×, current interest coverage is historically high. Higher debt costs would cut it to previous highs only.

Historical and current analyses do not guarantee future results.
EBITDA: earnings before interest, taxes, depreciation and amortization
*Reprice 27% of all existing debt to current market rates (8.5%); 27% represents the percentage of the US high-yield market maturing over the next three years. Historical data provided as weighted average from 1Q:08 to 1Q:23.
As of June 30, 2023
Source: Bloomberg, J.P. Morgan and AllianceBernstein (AB)

Strategies for Today’s Environment

In our view, bond investors can thrive in today’s environment by adopting a balanced stance and applying these strategies:

1. Get invested. We’ve recently observed that many investors, despite believing that yields will remain flat or fall over the next year, are underweight fixed income, with insufficient duration and credit exposure but meaningful exposure to the volatility of the equities market. We think that’s a dangerous game. The odds of meeting your investment goals over any reasonable horizon are much poorer when you’re not fully invested.

If you’re still parked in cash or cash equivalents in lieu of bonds—the T-bill-and-chill strategy made popular in 2022—you’re losing out on the daily income accrual provided by higher-yielding bonds. Indeed, overall income levels are the highest they’ve been in 16 years. For example, as of September 27, the global high-yield market offered yields of 9.4%, on average, compared to three-month T-bills at 5.6%. Remember, fixed-income returns are mainly derived from earning income with the passage of time.

What’s more, markets move swiftly, making market timing next to impossible. Once the tide begins to turn, sidelined cash tends to flood back into the market, rapidly driving yields down and prices up.

To us, it makes more sense to be early in this environment—locking in high starting yields and putting up with some near-term volatility as markets react to economic releases—than to risk being too late.

2. Extend duration. If your portfolio’s duration, or sensitivity to interest rates, has veered toward the ultra-short end, consider lengthening your portfolio’s duration. As inflation falls, the economy slows and interest rates decline, duration tends to benefit portfolios. Then get tactical, modestly shortening the portfolio’s average interest-rate exposure when yields drift lower and modestly lengthening when yields rise. Government bonds, the purest source of duration, additionally provide ample liquidity and help to offset equity market volatility.

3. Hold credit. Yields across risk assets are higher today than they’ve been in years, giving income-oriented investors a long-awaited opportunity to fill their tanks. “Spread sectors” such as investment-grade corporates, high-yield corporates and securitized assets—including credit-risk-transfer securities—can also serve as a buffer against inflation by providing a bigger current income stream.

But credit investors should be selective and pay attention to liquidity. CCC-rated corporates (particularly in cyclical industries), lower-rated emerging-market sovereigns and lower-rated securitized debt are most vulnerable in an economic downturn. Conversely, short-duration high-yield debt offers higher yields and lower default risk than longer debt, thanks to an inverted yield curve. Careful security selection remains critical.

4. Adopt a balanced stance. Striking the right balance between interest-rate and credit risks can be a good idea in the late stages of a credit cycle. Among the most effective strategies are those that pair government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio. This approach can help managers get a handle on the interplay between risks and make better decisions about which way to lean at a given moment.

Correlated sell-offs 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 may be tempted in such situations to sell—and lock in losses—in both.

5. Consider an active systematic approach. Today’s environment of higher rates and challenging economic conditions also increases opportunities in the form of higher potential real returns and active fixed-income security selection. We believe that systematic fixed-income investing approaches, which are highly customizable, can help investors harvest these opportunities. Because systematic approaches depend on different performance drivers, their returns will likely differ from—and complement—traditional active strategies.

Take in the View from Higher (Yield) Elevations

Active investors should stay nimble and prepare to take advantage of quickly shifting valuations and fleeting windows of opportunity as the year progresses. Most important, investors should get off the sidelines and fully invest in the bond markets to take advantage of today’s high yields and potential return opportunities. After all, the view up here is hard to beat.

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. Views are subject to revision over time.

About the Authors

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