Gershon Distenfeld: I think in the over two decades we’ve worked together, Matt, we’ve dealt with our fair share of uncertainties. You might even say that uncertainty is just a constant in our markets. But it seems like today, we’re in an environment where the uncertainty meter is even higher. We’re two years into a pandemic, Russia has recently invaded Ukraine, and we’re seeing inflation at levels that we haven’t seen in four decades.
How is an investor supposed to make sense of all this?
Matt Sheridan: We’ve seen a sharp increase 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.
So, we can generate a little bit more income on the duration portion, and we can also generate a little bit more income with wider spreads in the credit portion, assuming that we’re comfortable with the credit risk that comes with that type of volatility.
GD: Usually, wider spreads come with increased default risk. We actually think that 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.
So, while there might be some volatility in the short run, given the macro themes that you’ve hit on, Matt, we don’t expect much in the way of losses or defaults over the next few years, which makes today a pretty attractive entry point for high-yield credit.
MS: For our clients, we think it’s an attractive opportunity to generate more income, both in the duration portion and in the credit side, without a lot of future defaults priced in.
GD: You know, Matt, when you’re looking at shorter-term performance – what happens over the next three to six months – yield doesn’t tell you a whole lot. There are times when yields have been high and you have poor returns, there are times when yields have been low and you have good returns.
But when you look at yield versus a little bit longer timeframe, maybe around five years, there seems to be a much higher correlation, can you expand upon that?
MS: Yield to worst is a very strong, reliable predictor of what future returns will be for investors if they hold an investment to maturity, or over a four- to five-year time period.
If you look at the yield to worst on the High Yield Index and go back to, arguably, one of the most challenged or worst times to be an investor in high yield, if you bought high yield back in May of 2007, the yield curve was slightly inverted, credit spreads were close to all-time tights, and the yield to worst and the High Yield Index was 7.3% back in May of 2007.
If you held onto that investment for the next four to five years, throughout the global financial crisis, that investor would’ve earned, over the next five years on an annualized basis, 7.7%. So, slightly more than the yield to worst that you started with. That’s arguably the worst time to be a high-yield investor, and still, you generated really healthy returns.
GD: The problem with owning the riskier part of the high-yield markets is that it can be very volatile, and that unnerves some investors.
You and I have been big proponents, over the past couple of decades of working together, of what’s known as the barbell approach, mixing in some of that very high, volatile spread sectors, high-yield emerging markets, with interest-rate duration, US Treasuries and other government securities. Is that a style that should still work in today’s environment?
MS: It’s worked for the last 20 years. We have high conviction that the strategy should work very well in the future.
Correlations between high yield and US Treasuries have turned modestly positive. I would expect that to revert to more normal low to negative correlation in the future.
The beauty of adding Treasuries, as you build a portfolio, it’s very liquid, you can minimize some of the drawdowns, and you can take advantage 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.
GD: I think that’s a really important point, because as yields have been low for most of the past 15 years, we have seen, on average, curves be steeper, and you’ve gotten a lot of roll-down, roll-down being longer bonds just with the passage of time become shorter bonds and trade at lower yields. That’s not going to be there as much today, so you’re going to need more returns from the absolute yield component of the Treasury.
MS: But when we look at the Treasury market and what’s priced in, we have 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 as many rate hikes that are priced in, investors will likely be very happy that they own some portion of their funds in US Treasuries.
So, not only can you earn that attractive yield, we’ve seen a reprice in yield in the last six months. It acts as a good mitigant if credit spreads do widen more than we would expect, from a base case point of view.
GD: Ultimately, yield is what generates returns in fixed income, and yields are just a lot higher today across the board than they were just a few short months ago. That means that investors are likely going to be rewarded for either holding or adding to their fixed-income positions today.
Gershon Distenfeld is Co-Head of Fixed Income and Matt Sheridan is Portfolio Manager—Global Multi-Sector 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.