What to Think About in a Bond Market Reboot by Alison Martier, AllianceBernstein

US interest rates are likely to head up gradually over the next several years, now that the long tailwind from a three-decade-long rate decline has subsided. With bonds still an important part of many portfolios, what should investors be thinking about?

It’s certainly going to be a more challenging world for fixed income. As with many segments of the global capital markets today, there aren’t many broad swaths of the bond market that are still cheap. This should keep bond returns generally modest going forward.

But bonds continue to play a valuable role for many investors—whether it’s by generating a certain level of income or by acting as a steady counterbalance to the ups and downs of equity-market exposure. With these needs in mind, here are a few things for bond investors to think about:

Fixed income isn’t over the hill. Based on the median forecast from US Federal Reserve Board members, the fed funds rate will rise from near zero at the end of this year to 1.5% by the end of 2015 to near 4% by the end of 2017. That’s a fairly gradual pace—“slow and steady,” as we like to say.

The bond market expects the moves to be even more gradual, and we expect some bouts of volatility as the Fed engineers the path to “normalization.” As interest rates rise, bond performance, particularly for high-quality bonds, is likely to be relatively modest. But we don’t think investors should worry about a major bond sell-off like the ones in 1981 or 1994.

Think global, but forget currency. The US isn’t the only game in town when it comes to the global bond market. And the US economic and rate cycles don’t define what’s happening in other countries. The divergence we see developing in global growth, economic policies and interest-rate paths creates opportunity for bond investors.

US rates will likely rise, but in the euro area and Japan, where growth is weaker, it’s not hard to see rates staying low or even falling. These different trajectories will likely drive different bond-market returns. Because these patterns vary over time, we believe that including some global bond exposure can diversify interest-rate risk and offer chances—by picking winners and avoiding losers—to boost returns.

But watch the currency exposure. Exposure to a variety of global currencies has substantially increased the volatility of a bond portfolio, so we think hedging currency risk in a global bond portfolio is the way to go.

Diversify in credit and avoid crowds. Credit exposure has historically provided insulation against rising rates. That’s because rising rates are often driven by stronger economic growth, and stronger economic growth means better business conditions for corporate bond issuers.

However, the extra yield that corporate bonds offer versus Treasury bonds has fallen back to its historical average, so there’s no free lunch from credit exposure—and some areas are downright expensive. We see two such “crowded” segments in credit that pose significant risks: high-yield bank loans and CCC-rated high-yield bonds.

We think a better approach is to diversify credit exposure across a broad set of market segments, including traditional corporate high yield, emerging-market debt and even investment-grade credit. A wider net may improve diversification, while research and selective investing may capture attractive income-generating opportunities.

Manage liquidity risk—but don’t miss opportunities. During times of stress, market activity tends to dry up. When this happens, the required yield spread on less liquid investments balloons and prices fall. The cost of liquidity expands or contracts based on market conditions—in times of stress, liquidity costs are higher.

The need to manage liquidity risk has grown—but so has the opportunity to take liquidity risk in stressed areas of the market. To do this, we think it makes sense to consider some exposure to a bond strategy that isn’t bound by traditional broad-market benchmarks. Unconstrained strategies can be more nimble in accessing pockets of illiquidity opportunity—and their flexibility enables them to dynamically balance different bond risks.

To sum up: we don’t think bond investors should be worried about a major market sell-off, but we do think it makes sense for them to retool their bond exposure for what’s likely to be a very different ride going forward from that of the past three decades.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Alison Martier is Senior Portfolio Manager of Fixed Income at AllianceBernstein Holding LP (NYSE:AB)

What to Think About in a Bond Market Reboot