Finding Equilibrium in Fixed-Income Investing

After a dismal past few years, with high interest rates and inflationary pressures keeping many investors on the sidelines, bond markets staged a sharp rebound in late 2023.

Some of the market momentum faltered in the first quarter of 2024, as investors scrutinized every new economic data point to divine the timing of the first central bank rate cuts. But those who are overly focused on data surprises may lose sight of the bigger picture: Central bank rate cuts are coming, and with them a major opportunity for bond investors.

Here’s what else we think is in store for the rest of the year.

Growth

is set to slow due to the lagged impact of tighter monetary policy

Inflation

should decelerate but remain slightly above central banks' targets

Rates

should remain "higher for longer" but first cuts are likely in 2024

Credit

fundamentals are still robust and high yield default rates will be manageable

Time to Get Invested

Now that central banks appear closer to cutting interest rates, investors may be looking to time their entry back into the bond markets. Timing is important because historically, investors captured the most returns when they invested several months before the start of a first rate cut. So those who are ahead in returning to the bond markets look well positioned for potential returns.

Historically, Early Birds Enjoyed the Strongest Bond Market Returns

Bloomberg US Aggregate Bond Index: Average 12-Month Forward Return (Percent)

The US Aggregate averaged 13.8% for the year starting 3 months before the 1st rate cut, and 8.6 starting one month after it.

Historical analysis does not guarantee future results.
Average is based on the following dates of first Fed rate cuts: September 20, 1984; June 7, 1989; July 6, 1995; January 3, 2001; September 18, 2007; and August 1, 2019.
As of December 31, 2023
Source: Bloomberg, US Federal Reserve and AB

Investment Grade, High Yield or Both?

Income-seeking investors may be more inclined toward investment grade (IG) bonds—such as government bonds or credits rated BBB or higher—than higher-yielding debt as the global economy is set to moderate. That’s understandable.

IG bonds tend to be less risky than high yield (HY) ones, and usually deliver a lower return. On the other hand, HY bonds typically offer higher returns but with more risks, as the issuers are considered to have a greater chance of default. Historically, HY bonds have also taken a hit when growth slowed.

That said, we think income-seeking investors could tap high-quality high yield to complement IG bonds or for better return potential. Today’s high-yield bond issuers are in much better shape financially than issuers entering past slowdowns, thanks in part to the extended period of uncertainty surrounding the coronavirus pandemic. This uncertainty led companies to manage their balance sheets and liquidity conservatively over the past few years, even as profitability recovered. As a result, leverage and coverage ratios, margins, and free cash flow improved.

To reduce some credit risk, investors may also cut out low-quality, CCC-rated bonds, the riskiest slice of the high-yield universe. These securities are at the highest risk of default, and steering clear might make sense during the late stages of a credit cycle when economic conditions are tough for corporates. This approach would concede a small amount of return in exchange for significantly lower default risk.

What You Should Consider

Risk Mitigation
The Right Mix of Bonds
Find Ballast in a Diversified Bond Portfolio

Risk Mitigation

Including both investment grade bonds with higher-yielding ones in an investment portfolio can help reduce overall risk exposure because their returns are usually negatively correlated. When riskier, growth-oriented credit assets such as high-yield bonds fall in value, government bonds and other interest-rate-sensitive assets usually rise, and vice versa.

Because negatively correlated assets tend to take turns outperforming each other, investors can sell the outperformers on one side (for instance, high-quality high yield) and buy the cheaper bonds on the other (for example, Treasuries). That approach has historically tended to increase returns over time.

The Right Mix of Bonds

Getting the right mix of bonds will depend on each investor’s needs and comfort level.

For instance, an investor with high income requirement and a high-risk tolerance may have an even split between IG and HY bonds.

Another investor who wants high income but has a lower risk appetite may be inclined to have a heavier exposure to IG bonds than HY debt, giving up a small amount of return in exchange for lower risk.

In practice, investors seeking an optimal mix would also likely allocate to a wide variety of higher-yielding fixed-income sectors, including not only high-yield bonds but also corporate and hard-currency emerging-market debt, inflation-linked bonds and securitized assets.

Find Ballast in a Diversified Bond Portfolio

There’s no one way to build a well-diversified bond portfolio. Both government bonds and credit sectors have a role to play in portfolios today. Among the most effective strategies are those that pair high quality IG bonds and other interest-rate-sensitive assets with higher-yielding corporate bonds in a single, dynamically managed portfolio.

By investing in a mix of fixed income securities with different credit ratings, issuers, maturities, and sectors, investors can create a diversified bond portfolio that provides a balance of income, capital preservation and growth potential.

Why AB for Fixed Income?

Experienced Investment Teams

For over 50 years we have applied innovative research and award-winning portfolio management to help our clients navigate global bond markets. Consequently, we are one of the world's most recognized leaders in the asset class, with around US$255bn in fixed income assets under management as of 31 December 2023.

Rigorous Research

We adopt an integrated approach that combines fundamental and quantitative analysis. Fundamental research gets us up close to bond issuers, while quantitative insights give us an objective and systematic way to evaluate them. Our disciplined investment process combines these insights to help us identify our highest conviction opportunities.

Leveraging Leading Technology

The team incorporates cutting-edge technologies such as artificial intelligence with our electronic research platforms, and ESG considerations, to construct portfolios that deliver better outcomes for our clients.

Explore our Range of Fixed Income Funds

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