Generating Stable Returns in Uncertain Times

Low yields will continue to be a tough challenge. The big question is, how will central bank intervention play out? Quantitative easing (QE) buoyed up asset prices and created gains for investors. Coming into 2019, markets expected continuing strong growth and further rate rises in the US, together with continuing steady recovery in the euro area. These conditions would likely support the reversal of QE and a secular shift to a quantitative tightening (QT) stance. Now growth and inflation expectations have moderated, and the appetite globally for further tightening has diminished, for the time being at least. But investors should expect higher volatility—and probably lower returns— from the traditional parts of the market that are no longer benefiting from central banks making net new bond purchases.

The sell-off in the latter half of 2018 gave us a great opportunity to buy credit at attractive prices. Credit spreads had widened on increased supply and fears of the start of QT in Europe. Now that QT has receded, credit spreads have tightened quite nicely.

We still see scope to increase credit exposures—but with economic growth forecasts continuing to ratchet down, we want to make sure we’re buying the issuers who are well set to weather a turndown in the global economy.

A slowing economy and higher leverage in bond markets mean potential credit-rating downgrades ahead. The part of the market that investors are most concerned about is BBB, the lowest-rated tier of investment grade. Since the financial crisis, the size of the US bond market has more than doubled, and over that period, the proportion of BBB-rated securities has gone from one-third, up to 50%. So the concern is that there could be downgrades to a very large volume of fixed-income assets.

Now, if we look at our own internal forecasts, we currently assume that maybe 3%–4% of that BBB market is already priced in line with lower-rated high yield (HY)—so the downside will be limited if downgrades occur. But in a worst-case scenario, perhaps 15%–20% of BBB bonds are going to be downgraded to HY, which will hit prices hard. HY markets might struggle to cope with a lot of new supply in the form of downgraded former investment-grade bonds—particularly because these would typically have longer maturities than HY investors are used to. Even so, we think it’s important to keep this outlier risk in perspective—the more likely outcome is that the downside risk is more modest, and that careful credit analysis will uncover attractive opportunities in BBB bonds that have become oversold and undervalued.

The rally in markets earlier this year has more than recovered all of 2018’s losses, leaving valuations quite stretched. That means investors will need to be selective in the months ahead and avoid overconcentration in any one sector or region. So a fully global, dynamically managed approach will be very important.

In the longer term, higher inflation is a potential problem for fixed-income investors. We think the rising tide of populism is changing the political landscape, and that governments will need to respond by redressing the imbalance that has grown up between the owners of capital and workers. We feel that populist policies will likely lead to wage inflation through time, and higher inflation in general. In this scenario, a focus on shorter-dated bonds and a nimble risk-aware approach will help.

Harnessing new technology and machine learning is critical to our success at AB. We’ve developed our own trading platform, called Alpha, which aggregates all the data from different trading platforms in the various bond markets. This information advantage gives us a real edge. It means we can find the bonds that we want and trade them quickly, in what are becoming increasingly fast-moving and less liquid markets.

We’ve also introduced a digital assistant into our investment process, a chatbot called Abbie. Abbie’s first job was to improve our speed in orderbuilding, which was previously a time-consuming manual process. But as Abbie has learned new skills, she is now able to access all our different research inputs, and to make trade suggestions too. We are continuing to help Abbie develop new skills, and at each stage of her development she is making us much faster and more efficient in originating and executing ideas.

Currently, we like: high quality bonds that will be resilient even in a slowing economy; bonds with very low sensitivity to interest rates; shortdated high quality credit instruments; and cash and cash proxies that we can use very quickly to buy credit bonds when setback periods create opportunities.

We believe that changes in government and central bank policies will drive volatility higher, triggering episodes where credit spreads spike. That’s the sort of environment where dynamic management and a disciplined investment approach can really pay off.