When we think about generating income for our clients, for over 30 years we’ve thought the most efficient way to do this is to blend the two key risks of fixed income into one portfolio. The two key risks of fixed income are interest-rate risk and credit risk, and there typically we invest in high yield. The attractive function of that is it’s a very liquid portfolio.

The range of outcomes in 2023 seems to be a little bit larger than normal, meaning if inflation continues to surprise to the downside, capital market returns across the board should be very strong for the rest of the year. Now, of course, that’s a big “if.”

The Federal Reserve is highly focused on inflation being higher than their long-term target of 2%. And the longer it takes for inflation to come down to that target, the probability of recession in 2023 or beyond continues to increase.

The interest-rate-sensitive sectors in the US are slowing, the largest one being US housing. Housing has slowed for the last six to eight months here, and will likely continue to slow. Certainly not the end of the world, but again, until the Fed begins to relent, or until the Fed feels a little bit more comfortable that core inflation is moving towards 2%, the probability of recession is rising in the US.

In that type of scenario, we tell clients to focus on improving liquidity, lean into US Treasuries. High-quality high yield still offers attractive upside, or attractive carry, for the near term, but you probably want to be a little bit more defensive with assets that have much more potential default risk or drawdown risk.

Duration and high yield is often negatively correlated. 2022 is the outlier. But in most environments, the negative correlation between duration and credit works extremely well. It allows you the ability to rebalance when high-yield spreads widen and interest rates decline because investors think the Fed is going to offset that poor economic performance. We can increase our yield in a very cost-effective manner, and conduct it very efficiently.

We don’t only invest in high yield though. We also look to diversify, or minimize, the amount of triple-C risk for credit volatility purposes or potential default risk. We will allocate capital into emerging markets, typically hard-currency EM sovereigns, or corporates, and also opportunistically into securitized bonds, typically focused on US housing and the US commercial real estate.

We like the secured nature of securitized bonds. We think the prior house price appreciation limits the potential drawdown, especially in today’s environment, as investors are increasingly worried about a potential slowdown in US and global economies.

Leave dry powder, be ready to rebalance if our base-case view of modest growth is not right. And it’s really all going to be about inflation. If inflation surprises to the upside, be a little bit defensive here.

Matt Sheridan is Portfolio Manager—Income Strategies 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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