It’s been a long and winding road, and most investors are feeling a bit queasy. That begs the question: Are we there yet? Probably not. Below, in our midyear outlook, we address stubbornly high inflation, rising interest rates, the increased risk of recession and the repricing of credit—and provide strategies for steering through tough conditions.

Backseat Driver: Inflation

Inflation remains top of mind for investors and policymakers alike. Prices are rising at a rate not seen in generations, confounding expectations that a broader reopening of the global economy would ease pressures. Instead, a perfect storm of disruption—from Chinese pandemic lockdowns to Russia’s invasion of Ukraine—has pushed prices ever higher.

Central bankers have responded by tightening monetary policy to slow demand to a rate consistent with supply. The US Federal Reserve has raised rates 150 basis points since March and isn’t finished. Central banks in the UK, Canada, Australia and New Zealand are also hiking, and the European Central Bank appears poised to do the same in July. Many emerging-market (EM) countries are well advanced in their hiking cycles. Only the Bank of Japan and the People’s Bank of China are unlikely to raise rates due to idiosyncratic developments in their countries.

The catch is that monetary policy works with a lag. Once rates rise, it takes time for the economy to feel the full effect. But, as the year progresses, we expect growth to slow, bringing inflation gradually lower. The question is, will growth slow too much? It’s tough to engineer a soft landing, and it’s harder still when inflation is sticky and policymakers need to get aggressive. The risk of recession has risen and is contributing to significant market volatility and episodic liquidity challenges. But it’s also creating opportunity.

Shining a High Beam on Corporate Bonds

Tighter monetary regimes and a rising risk of recession are typically hazards for corporate debt. But there are several reasons we think investment-grade and high-yield bonds look attractive today.

First, today’s corporates have strong long-term fundamentals, which hasn’t historically been the case at the brink of an economic slowdown. 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 of uncertainty, even as profitability recovered.

Further, most issuers have extended their maturity runways since the start of the pandemic. That means there’s no approaching maturity wall, where a large share of bond issues mature and issuers are compelled to procure new debt at prevailing rates. In other words, companies will enjoy low coupons for many years to come, even if yields stay elevated for years. As a result, we expect defaults and downgrades to remain very low by historical measures over the next 12 months.

Second, at today’s wider spreads, corporate credit is compellingly valued. Yields and spreads are at multiyear highs, with investment-grade European corporates yielding more than 200 basis points more on average than in August 2021, when half the index offered negative yields. In just four months, US investment-grade corporate yields have risen from the 13th percentile to the 99th percentile when viewed over the past 10 years.

Because, like us, the market isn’t concerned about defaults, it isn’t demanding a premium for default risk. Instead, the premium for volatility is historically elevated. In other words, when market volatility declines from today’s levels, so too will spreads; and conversely, if market volatility increases, spreads will likely widen. We expect elevated volatility to persist for an extended period, keeping spreads wide. In this environment, “carry”—essentially, clipping the bond’s coupon—rules the day.

Third, today’s higher yields signal higher returns for high-yield bonds and other high-income asset classes. History shows that the high-yield sector’s yield to worst has been a reliable indicator of high-yield return over the following five years. In fact, high-yield bonds performed predictably through one of the most stressful periods of economic and market turmoil on record—the global financial crisis. During that period, the relationship between starting yield to worst and future five-year returns held steady. Why? High-yield bonds supply a consistent income stream that few other assets can match.

Steer into the Skid

Here’s how active investors can rise to the challenge in this environment:

Be dynamic. We expect heightened volatility and liquidity challenges to persist. Active managers should prepare to take advantage of quickly shifting valuations and fleeting windows of opportunity as other investors react to headlines.

Adopt 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 sectors. Yields across most risk assets are meaningfully higher today than they’ve been in years—an opportunity investors have been waiting 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.

High-yield developed-market corporate credits look especially compelling today. With the yield to worst on the Bloomberg Global Corporate High-Yield Bond Index averaging 9% and long-term fundamentals still favorable, investors with a longer-term lens can ride out short-term drawdowns. Even so, it’s prudent to be choosy when picking credits.

By contrast, we remain cautious about EM debt. Inflation risks have increased to the point that EM central banks appear willing to sacrifice growth to halt the inflation spiral—which may prove difficult, given the persistent food supply challenges caused by the war in Ukraine, among other factors.

Choose a balanced approach. Global multisector 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.

Create a Road Map for the Future

As the war in Ukraine continues, it’s not too soon for investors to start framing the secular issues that will undoubtedly reshape the way we analyze countries and companies and build portfolios for years to come.

For example, how will Europe change? As European countries recalibrate their energy strategies, will there be an accelerated push for renewables? Will the war change the way ESG investors think about defense companies?

Down the road, commodity markets may look very different than today, with potentially large changes in sources of production, as well as in transportation and refining capacity. Deglobalization may gather steam. What happens if more economies bring production back to their home markets? These are just some of the complex issues our investment teams are beginning to explore.

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 steer tactically to capture opportunities that arise when other investors overcorrect.

Scott DiMaggio and Gershon Distenfeld are Co-Heads of Fixed Income at AB.

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 change over time.

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