Fixed-Income Outlook: Stormy Weather and Silver Linings

03 October 2022

4 min read

Gershon M. Distenfeld, CFA | Director—Income Strategies

2022 has been a stormy year for bond investors, and the forecast calls for more of the same. Below, we address today’s biggest investment challenges—from persistent inflation to rising rates to a looming recession—the silver linings of higher yields and wider credit spreads, and strategies for navigating bad weather.

The Storm: Global Slowdown, Stubborn Inflation

Rising prices continue to confound expectations that slowing global growth will ease inflation pressures. While the US Federal Reserve and other central banks are aggressively hiking rates to combat inflation, most drivers of today’s high inflation are outside of central banks’ control. The war in Ukraine and the COVID pandemic continue to disrupt fuel, food and goods supply chains, feeding high inflation and throttling global economies.

Sticky inflation may compel central banks to tighten monetary policy still further, which increases the potential for a global recession. In turn, fear of recession is leading investors to take refuge in the US dollar, the world’s reserve currency. As their own currencies tumble, other countries feel the pain of both the strong dollar and higher interest rates. Emerging-market (EM) countries are especially vulnerable, since their sovereign debt is often issued in US dollars; when the dollar strengthens, their debt burden increases.

The upshot? Financial market turbulence may be here to stay for some time.

The Silver Lining: Higher Yields

The risk of recession is contributing to market volatility and episodic liquidity challenges, but it’s also creating opportunity. Investment-grade corporate yields and spreads are at multiyear highs (Display), and the yields on high-yield debt now average 9.5%.

Investment-Grade Corporate Bond Yields Are at a 10-Year High

Bloomberg Global Aggregate Credit Index: Yield to Worst and Option-Adjusted Spread

Corporate yields trended down from 2009 until recently. They’ve now surged to 4.5%, the highest level in the 12 years shown.

Through August 31, 2022
Source: Bloomberg

The specter of a recession usually scares investors away from corporate debt. Credit fundamentals tend to have weakened prior to any slowdown, causing issuers to enter a downgrade and default cycle as growth and demand slow further. But today’s situation is different.

Today’s issuers are in better shape financially than issuers entering past recessions. The corporate market went through a default cycle just two years ago when the pandemic hit. The surviving companies were the strong ones—and they’ve managed their balance sheets and liquidity conservatively over the past two years, even as profitability recovered. Thus, we expect defaults and downgrades to rise only to average levels over the next year.

Meanwhile, today’s higher yields signal higher potential returns ahead. For example, the high-yield sector’s yield to worst has been a reliable indicator of high-yield return over the following five years (Display).

Five-Year Returns Have Closely Tracked Yield at Start of Period

.): Starting yield and 5-year return closely correlate for 6 crisis periods over the last 20 years. Today’s yield is 9.5%.

Historical and current analysis and forecasts do not guarantee future results. An investor cannot invest directly in an index, and its performance does not reflect any fees and expenses or represent the performance of any AB fund.
*Yield to worst as of date shown
†Annualized five-year return beginning on date shown
As of September 26, 2022
Source: Bloomberg and AllianceBernstein (AB)

In fact, high-yield bonds performed predictably through the global financial crisis, one of the most stressful periods of economic and market turmoil on record. During that period, the relationship between starting yield and future five-year returns held steady, thanks largely to bonds’ consistent income stream.

Strategies for Surviving and Thriving

Here’s how active investors can rise to the challenge in today’s environment:

Be nimble. We expect heightened volatility and liquidity challenges to persist. Active managers should be ready to take advantage of quickly shifting valuations and fleeting windows of opportunity as other investors react to headlines.

Seek (inflation) protection. Because inflation is likely to remain elevated for some time before it falls back to target, explicit inflation protection, such as Treasury Inflation-Protected Securities and CPI swaps, can play a useful role in portfolios.

Lean into higher-yielding credit. Yields across risk assets are much higher today than they’ve been in years—an opportunity investors have been waiting a long time for. “Spread sectors” such as investment-grade corporates, high-yield corporates and securitized assets, including commercial mortgage-backed securities and credit risk–transfer securities, can also serve as a buffer against inflation by providing a bigger current income stream.

Choose a balanced approach. Global multi-sector approaches to investing are well suited to a quickly evolving landscape, as investors can closely monitor conditions and valuations and prepare to shift the portfolio mix as conditions warrant. Among the most effective active 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 rate and credit risks and make better decisions about which way to lean at a given moment. The ability to rebalance negatively correlated assets helps generate income and potential return while limiting the scope of drawdowns when risk assets sell off.

For now, we encourage bond investors to fix their eyes on the horizon. By taking a longer view, investors can avoid overreacting to today’s headlines—even as they shift tactically to capture opportunities that arise when other investors overcorrect.

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

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

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

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