Income Inflation Late-Cycle Investing Rising Rates Volatility Fixed Income Blog

Fixed-Income Outlook: Stormy Weather and Silver Linings

03 October 2022
4 min read
Below, a dark, roiling sea. Ahead, receding black storm clouds. Above, a fringe of silvery, cottony clouds, backlit by the sun.
Scott DiMaggio, CFA| Head—Fixed Income
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

As Co-Head of Fixed Income and Director of Global Fixed Income, Scott DiMaggio oversees all of AB's Global Fixed Income, Canada Fixed Income and US Multi-Sector Fixed Income strategies, as well as their associated investment strategy, activities and portfolio-management teams. 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.

DiMaggio came to AB as a quantitative analyst, drawn by the firm's culture of strong mentoring and smart, collaborative people who wanted to win for their clients.

"The world of fixed income—the world I grew up in—is enormously complex," DiMaggio says. Its complexity needs an active management approach. His investment philosophy combines the lenses of fundamental and quantitative research to generate the information that can lead to risk-adjusted returns for clients. Fully leveraging AB's proprietary technology, it's a process that DiMaggio and his team refine and repeat.

"What we do is process driven and structured," DiMaggio says. "We like to be consistent."

Gershon M. Distenfeld thrives on facing challenge, solving problems and putting people with different personalities and different viewpoints together to "make the engine run." When he joined AB in 1998 from a role as an operations analyst at Lehman Brothers, Distenfeld had long been fascinated by the high-yield market, and he led that practice at AB from 2006 to 2016 before assuming responsibility for all of credit. He has been co-head of fixed income since 2018.

In an industry that tends to focus on the short term, Distenfeld's investment philosophy takes the long view, considers a range of outcomes and focuses on the downside. This approach puts process and constant innovation at the forefront, making full use of AB's proprietary technology to mine the insights of fundamental and quantitative research.

"We're constantly reinventing ourselves," Distenfeld says. "We don't just sit still. We adapt to new information so we can find new factors that work."

Distenfeld's eye toward the long view extends to his charitable work with organizations like New Jersey NCSY. This youth organization for disaster relief partners with Habitat for Humanity and NECHAMA to repair homes and lives affected by natural disasters.