Three Income Themes for Multi-Asset Investors in 2023

23 November 2022

9 min read

Karen Watkin, CFA| Portfolio Manager—Multi-Asset Solutions

Edward Williams| Investment Strategist—Multi-Asset Solutions

In one of the most challenging years for markets, 2022 brought persistently high inflation, aggressive central bank tightening and heightened geopolitical risks, leaving investors with few places to hide. With major sell-offs and dislocations in practically every corner of the market, traditional stock-bond mixes like the 60/40 have struggled. As a result, many income investors are uneasy about what to expect in 2023.

Income Options Are Broader than Many Investors Think

The landscape for multi-asset investors, particularly those on an income path, has shifted dramatically. Yields began the year at the bottom of their 10-year ranges but will likely finish near decade highs (Display). High-yield credit, for example, offered a yield to worst of 4.2% in late December 2021, not much more than high-dividend equities. Now, it’s more than doubled that level.

The Yield Environment Has Shifted Dramatically in 2022

(Percent)

Yields for seven key asset classes all rose from 10-year lows to 10-year highs from late 2021 through October 31.

For illustrative purposes only.
As of November 17, 2022 (current) and October 31, 2022 (10-year)
Source: Bloomberg and AllianceBernstein (AB)

This scenario played out across income-generating investments, including investment-grade bonds, hurting near-term returns for income seekers. But it also leaves investors with a wide range of opportunities, provided they have the flexibility to consider a broad spectrum of asset classes.

Looking to 2023, we think income-oriented multi-asset investors should consider three key themes:

1. Seek Diversified Sources of Equity Return

Income investors naturally favor the reliability of high-dividend stocks, especially lately. With their defensive characteristics (stable income streams and more mature business models), dividend-payers proved steadier as markets grew choppy during the year—in fact, the sell-off for high-dividend stocks was half that of cap-weighted equities in 2022.

If market volatility and economic uncertainty persist, high-dividend outperformance may continue. Then again, market leadership across equity styles and sectors can change hands over time. That’s why we believe that investors should pursue high-dividend equities with a systematic, factor-based approach in order to better balance sector and style exposure. This can help avoid concentration risk, which tends to occur in more “vanilla” approaches to dividend income (Display).

Dividend payers and global stock weightings look different, which has helped divided stocks’ upside growth potential.

For illustrative purposes only.
As of October 31, 2022
Source: MSCI and AB

Beyond high-dividend stocks, investors should look to profitable, resilient companies trading at attractive valuations. We consistently find that companies with sustainable earnings, stable cash flows and capital-spending discipline have outperformed and, with future volatility still uncertain, can help dampen the downside.

This “quality, stability and price” discipline has also outperformed the market when inflation runs high and fast. As prices rise, companies face pressures on both the cost and income sides of their ledgers. High-quality companies with strong cash flows have more ways to protect their margins. These stocks also complement high-yield credit very well, since high-yield issuers generally tend to have more leverage and unproven track records by comparison.

2. Consider High-Yield Credit

Credit is another important income source, especially with yields up so dramatically. As global central banks aggressively raise interest rates to curb inflation, credit yields have soared and valuations are much more attractive than they were this time last year.

High yields aren’t the whole story, however; the fundamental backdrop matters too. Bottom-line pressures usually intensify this late in the business cycle: corporate excesses build and shrinking demand and tightening credit conditions challenge companies to raise capital at affordable rates.

Fortunately, we’re not seeing such high distress levels in the current late-cycle environment. Issuers’ fundamentals remain strong and of high quality, and they took advantage of low rates during the pandemic to restructure debt and extend maturities. Today, high-yield debt-servicing ability is its strongest in many years, while valuations remain very attractive—especially versus equities (Display).

High-yield issuer debt levels are historically low, and trading at their cheapest levels relative to global stocks since 2009.

For illustrative purposes only.
*Relative valuation measured as HY CDX OAS–S&P 500 earnings risk premium
†Net Leverage=net debt/EBITDA; Interest Coverage=EBITDA/interest
As of October 31, 2022 (left) and November 18, 2022 (right)
Source: BofA Securities, IHS Markit, S&P and AB

We expect default rates, now at historic lows, to rise but stay below averages—and well under levels seen in past recessions. US high-yield issuer ratings reflect this; more than half of issuers by market value are now BB-rated, and those with CCC ratings are at the lowest level in more than a decade.

Moreover, the high-yield bond index leans structurally toward energy and less toward technology firms, in contrast to the broad equity market. So, with energy currently benefiting from elevated commodity prices, high-yield exposure is a helpful equity diversifier (Display).

High-Yield Bonds Offer Sector Diversification to Equities

(Percent)

High-yield’s overweight energy, and underweight technology, is a strong diversifier to equities, where the opposite is true.

For illustrative purposes only.
Global High Yield represented by ICE BofA US High Yield Index; Global Equities, represented by MSCI World Index
As of October 31, 2022
Source: ICE Data Indices, MSCI and AB

Credit valuations and fundamentals are relatively favorable. But caution and selectivity remain the watchwords if heightened volatility, rising rates and late-cycle dynamics continue to play out in early 2023.

3. Revisit the Role of Government Bonds as Diversifiers

Global treasury bonds have long been viewed as a safe haven asset—a reliable backstop during periods of market stress. In 2022, though, high inflation and rising rates sapped government bond returns as equities tumbled, eroding the traditional diversification benefit of duration exposure.

Sharply rising bond yields made holding government bonds somewhat painful for most of 2022, but we think they still have a role within multi-asset income strategies in 2023. Their yields are the highest in 10 years, making them a viable income source. In our view, current yields have largely priced in the risks of further monetary policy tightening, so we expect less volatility and downside risk from here.

The diversification benefits of government bonds could return now that inflation is showing signs of peaking, based on historical trends. We expect the correlation between stocks and bonds to again help diversify returns (Display) and reduce downside risk if we enter a stretch of economic stress.

High Inflation Has Caused Stock-Bond Correlations to Rise

Stock-Bond Correlation vs. US Core CPI

As the US core CPI rose, stocks and bonds have underperformed in tandem, which has sapped their diversification benefits.

For illustrative purposes only.
Chart shows 52-week trailing correlation of weekly returns between S&P 500 and US 10-year Treasuries.
As of October 31, 2022
Source: Bloomberg, S&P and AB

To sum things up, the outlook for 2023 may feel somewhat gloomy, with growth potentially slowing, inflation still high and tighter financial conditions. But compelling valuations, combined with higher yields across a range of fixed income and equities, could make next year a brighter one for income investing. Staying flexible and selective in asset-allocation exposures will be key to success.

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

Karen Watkin, CFA

Karen Watkin is a Senior Vice President and Portfolio Manager for the Multi-Asset Solutions business in EMEA. Along with being Portfolio Manager for the All Market Income Portfolio, she is responsible for the development and management of multi-asset portfolios for a range of clients. From 2008 to 2011, Watkin was portfolio manager for the Index Strategies Group, responsible for the development and management of AB’s custom index strategies for institutional clients in EMEA. She joined the firm in 2003, after spending three years as a management consultant in the Capital Markets Group at Accenture. Watkin holds a BA in economics with European study from the University of Exeter and is a CFA charterholder. Location: London

Edward Williams

Edward Williams is a Vice President and Investment Strategist within the Multi-Asset Solutions team, where he is responsible for the business development of AB’s Luxembourg income-thematic multi-asset strategies. Williams joined AB in 2020 when he was based in Hong Kong, supporting client activity across Asia, before relocating to London and into his current role. Prior to joining AB, Williams spent six years working at Fidelity International across a range of roles in Europe and Asia, including as an investment specialist, focusing on Fidelity’s risk-managed and outcome-orientated multi-asset solutions. He holds a BA in economics from the University of Reading. Location: London

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