Income opportunities have emerged in the wake of the sharp increases in US and global interest rates, both in emerging markets in 2021 and in developed market countries in 2022.
“When we look at non-Treasury spread sectors, we’ve also seen a moderate widening in credit spreads, and to us, that looks attractive,” said Matthew Sheridan, portfolio manager, income strategies at AB.
As a result, investors can generate a little bit more income on the duration portion, as well as from wider spreads on the credit side – assuming there is comfort with the credit risk associated with such volatility.
Yet investors don’t need to be too worried about the increased default risk from wider spreads, according to Gershon Distenfeld, co-head of fixed income, and director, credit at AB.
“In this case, that’s not going to happen. Only two years ago, we went through a down cycle, we had a lot of companies restructure, and not just due to Covid.”
An environment where there is little expectation of losses or defaults over the next few years potentially creates an attractive entry point for high-yield credit.
A balanced approach
This outlook suits the barbell approach that Distenfeld and Sheridan have taken over the past couple of decades – mixing some of the high, volatile spread sectors, high-yield emerging markets, with interest-rate duration, US Treasuries and other government securities.
“It’s worked for the last 20 years. We have high conviction that the strategy should work very well in the future,” added Sheridan.
While correlations between high yield and US Treasuries have turned modestly positive, he expects them to revert to more normal low to negative levels going forward.
Adding Treasuries to the portfolio helps to minimise some of the drawdowns, also enabling investors to capitalise on the situation by rebalancing into cheaper spread sectors when capital market stress hits.
“The beauty of owning US Treasuries in a balanced approach, is the US Treasury yield curve is relatively flat. Normally, what happens after you have a flat US yield curve environment, is that US Treasuries generate strong absolute returns as growth eventually begins to slow,” said Sheridan.
That’s not going to be there as much today, he added, meaning that investors will need more returns from the absolute yield component of the Treasury.
Delivering on yield
At the same time, given that a lot of rate hikes priced in in the US Treasury yield curve over the next 12 to 18 months, if the Fed does not deliver, then investors will likely be pleased to own some portion of their funds in US Treasuries.
“Not only can you earn that attractive yield, we’ve seen a reprice in yield in the last six months,” explained Sheridan. “It acts as a good mitigant if credit spreads do widen more than we would expect, from a base case point of view.”
