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Fixed Income Outlook

Keep an Eye on Systemic Risks in 2020

09 January 2020

5 min read

Gershon M. Distenfeld, CFA | Director—Income Strategies

From a fraught geopolitical landscape to a global slowdown, the major systemic risks in today’s investment landscape are impossible to ignore. We expect such risks to contribute to persistently low and negative yields as well as to bouts of volatility in 2020. With bond yields near historic lows, can fixed-income markets generate solid returns without forcing investors to take too much risk?

Evaluating Systemic Threats

Populist policies and geopolitical tensions—in many ways intertwined—are on the rise. Weaponized conflict isn’t the only risk. The trade war between the US and China has hurt global trade, causing business confidence to falter and manufacturing output to decline. Trade-sensitive economies such as Mexico and the euro area have been hurt the most, while ironically China and the US have seen less damage.

Washington and Beijing made progress toward a trade deal late last year, but some manufacturing indicators that have stabilized since then have done so at levels consistent with contracting output. At any rate, recent progress could reverse with a single presidential tweet.

Could the outcome of the 2020 US election resolve the volatility generated by a populist policy thrust? We don’t think so. Both wings of the US political spectrum support a shift toward trade protectionism, for example, while the center remains skeptical. Furthermore, the rise of populism is a global theme, as evidenced by the continuing and messy Brexit saga. According to the Tony Blair Institute for Global Change, the number of populist leaders around the world has increased fivefold since 1990.

Not coincidentally, the world economy now faces a challenging year and may be entering a protracted period of slower growth. A global slowdown could leave the world even more vulnerable to adverse shocks.

Central banks have sprung into action, and we may see further monetary easing this year. But it will be tough for easier monetary policy to be effective at a time when interest rates in much of the world are already at or below zero. And aggressive fiscal stimulus appears to be off the table, for now.

The picture isn’t entirely gloomy, however.

As measured by the steeper US yield curve, the market thinks the risk of a US recession has receded. We do too. US and other developed-market consumers continue to spend, and the US labor market in particular remains healthy.

In addition, China has targeted a real GDP growth rate of 6% for 2020. Meeting this target will require continued acceleration in policy easing in response to downward pressures, both internal and external. We expect Chinese stimulus to spill over to developed- and emerging-market economies and assets, thus helping to stabilize the global economy in 2020.

Nevertheless, it would be premature to declare that the world economy has turned a corner; the immediate threats we have identified reflect long-running trends.

Unearthing Opportunities

Accordingly, bond yields are likely to stay low for some time, while market volatility should remain high. But investors can still earn a decent return in their fixed-income strategies.

The 10-year Japanese government bond, for example, began the last three years with a yield near zero, and 11 of the last 12 years with a yield below 1%. But annual returns over this period averaged more than 2%. Likewise, falling yields in Europe have led to healthy price appreciation. The yield on the Bloomberg Barclays Euro–Aggregate Treasury Index began 2019 at 0.74% but earned a total return for the year of 6.77%.

It’s also important to “hold duration”—that is, to have exposure to the risk that interest rates will rise or fall—when there’s significant uncertainty on the global geopolitical stage. During periods of market turbulence, government bonds’ duration serves as an offset to equity and credit market volatility, mitigating downside risk.

But investors shouldn’t hold only government bonds. They should also take advantage of dislocations in credit-sensitive sectors that offer an appealing mix of yield, quality and downside protection potential. Two that we find attractive today are US securitized assets backed by commercial and residential mortgages and subordinated European bank debt.

Securitized assets have been a good way to offset trade-war-related volatility. Commercial mortgage-backed securities (CMBS) and credit-risk-transfer (CRT) securities have weathered the ups and downs of the US-China trade war better than US high-yield credit. They also have low correlations with other fixed-income sectors and other asset classes.

CMBS can boost portfolio income, as they offer a healthy yield pickup over corporate bonds. The sector has been out of favor in recent years, in part due to fears around a retail apocalypse—concerns that our research indicates are exaggerated.

Investors may also want to consider exposure to CRTs, residential mortgage¬-backed bonds issued by the US government-sponsored enterprises Fannie Mae and Freddie Mac. CRTs benefit from a still-solid US housing market, among other positive factors. Home affordability has improved in most regions, and while minor corrections in some high-income areas of the country may slow home-price appreciation, they’re unlikely to stop it outright.

We also think investors can boost yield potential without taking too much risk by allocating to subordinated European bank debt. These securities were issued to comply with the global Basel III regulations that required banks to build up equity capital buffers. Because they’re lower in the capital structure, subordinated bonds issued by investment-grade banks offer yields like speculative-grade securities. In fact, yields on European additional Tier 1 (AT1) bonds, the first securities that would take a hit if the issuing bank ran into trouble, comfortably outstrip those on European and US high-yield bonds.

And developed-market banks are broadly in good health today, making the risk/reward trade-off attractive. European bank debt is particularly attractive because European financials are in a slightly earlier stage of the credit cycle than their US counterparts.

What other credits look attractive in the later stage of the credit cycle? Perhaps surprisingly, BBB corporate bonds, which offer yields like those in the high-yield market. Many of these companies have prioritized debt reduction and still have healthy earnings. Within the high-yield market, shorter-maturity high-yield bonds may see more muted volatility.

Lastly, the dovish tilt by developed-market central banks is broadly supportive of emerging-market debt. The economic fundamentals of emerging-market countries have also markedly improved in recent years. We think these assets may get an added boost as monetary policy around the world gets even easier in 2020.

Putting It All Together

The era of low yields and the investment challenges they bring to fixed-income investors isn’t likely to end soon. But selective investments across regions and sectors, as well as a suitable balance of interest-rate-sensitive and credit-sensitive holdings, can reduce volatility and increase return potential as the world economy loses momentum. In an age of uncertainty, that’s a ray of light—even without 2020 vision.

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

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

This is a marketing communication. This information is provided by AllianceBernstein (Luxembourg) S.à r.l. Société à responsabilité limitée, R.C.S. Luxembourg B 34 305, 2-4, rue Eugène Ruppert, L-2453 Luxembourg. Authorised in Luxembourg and regulated by the Commission de Surveillance du Secteur Financier (CSSF). It is provided for informational purposes only and does not constitute investment advice or an invitation to purchase any security or other investment. The views and opinions expressed are based on our internal forecasts and should not be relied upon as an indication of future market performance. The value of investments in any of the Funds can go down as well as up and investors may not get back the full amount invested. Past performance does not guarantee future results.

This information is directed at Professional Clients only and is not intended for public use.

Fixed Income Outlook

Keep an Eye on Systemic Risks in 2020

Evaluating Systemic Threats

Unearthing Opportunities

Putting It All Together

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