Market twists and turns challenged fixed-income investors in the first quarter, as markets responded to swings in economic and inflation data and central banks struggled to control the wheel. Then, in March, the collapse of two large commercial banks triggered a significant repricing of risk and sent markets into a skid. Below are our key takeaways, as well as strategies for gaining traction in uncertain conditions.

Bank Failures Don’t Presage Another 2008

March’s sudden bank failures have revived investor fears of another global financial crisis. We don’t think that’s likely, mainly because banks are in much better shape today than in 2008. Thanks to stricter regulations put in place after the last crisis, they have far less debt and far fewer toxic assets on their balance sheets.

Recent events appeared sudden because of the speed with which today’s depositors and regulators react. Modern technologies give depositors more information more quickly and allow depositors to move their assets with just a few clicks on a smartphone. Likewise, regulators react more swiftly to relieve bank stress and respond to potential or actual failures. Within four days of the collapse of Silicon Valley Bank, the FDIC, the Federal Reserve and the US Treasury had implemented deposit guarantees and emergency term funding programs and signaled their willingness to do more, if necessary.

Thus, while we anticipate continued volatility in the banking sector, we don’t expect another global financial crisis. In fact, from a credit perspective, banks are in the best shape they’ve ever been.

The Banking Crisis Has Tightened Financial Conditions

In our analysis, the probability and potential severity of a recession have increased—not because we expect further bank failures, but because even the perception of increased systemic risk can have the effect of tightening financial conditions. Nonetheless, most major central banks have pressed ahead with their tightening regimes. The Fed, the European Central Bank and the Bank of England raised policy rates 25 to 50 basis points in the immediate wake of the bank failures.

We don’t think that’s because they’re tone-deaf. Rather, recent rate hikes signal central banks’ belief that the banking sector is robust enough to weather this episode. In fact, more conservative commercial bank behavior complements central banks’ policy objectives. Tighter bank lending standards mean less borrowing and spending, which helps policymakers slow growth and inflation and allows for smaller rate hikes than they would make otherwise.

Negative Correlations Are Back

Traditionally, investors have valued government bonds for their role as a “safe haven” when equity markets and other risky assets are in crisis.

But in 2022, equity and fixed-income markets broke with convention and fell in tandem, leaving almost nowhere for investors to hide. The uniformity of terrible returns was so unusual that market observers wondered whether the days of negative correlations between stocks and bonds were behind us.

Recent market events proved that thesis wrong. As risk assets sold off in March, US Treasuries enjoyed a strong rally, reestablishing the negative correlation between the asset classes in a risk-off environment. We expect this restored relationship to persist. Growth assets such as stocks and high-yield bonds tend to experience more volatility as the odds of recession increase and inflation expectations decline.

Strategies for Gaining Traction

Here’s how active fixed-income investors can thrive in today’s volatile environment:

1. Own duration. Get tactical when it comes to duration, or sensitivity to interest rates. This means modestly shortening the portfolio’s average interest-rate exposure when yields drift lower and modestly lengthening when yields rise. And if you’ve been parked in ultra-short investments, consider lengthening your portfolio’s duration now. As inflation falls and the economy slows, duration tends to benefit portfolios.

2. Favor higher-quality credit. Yields across risk assets are higher today than they’ve been in years, giving investors a long-awaited opportunity to fill their tanks. “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. But be selective and pay attention to liquidity. CCC-rated corporates (particularly in cyclical industries), lower-rated emerging-market sovereigns and lower-rated securitized debt are most vulnerable in an economic downturn. Careful security selection remains critical.

3. Choose a balanced approach. 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.

4. Be nimble. Active managers should prepare to take advantage of quickly shifting valuations and fleeting windows of opportunity as other investors react to headlines. In general, global multi-sector approaches to investing are well suited to a dynamic economic and financial market landscape, as investors can monitor conditions and valuations and shift the portfolio mix across sectors and geographies as conditions warrant.

Stay Positive

We expect continued volatility over the next few months as central banks and the capital markets respond to swings in economic and inflation data. But ultimately, while market conditions may be unpredictable, bond investors have many tools at hand for gaining traction. Given today’s higher yields and—as the year progresses—a lower-growth and lower-inflation environment, we feel optimistic about fixed-income returns for 2023.

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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