Two key risks in fixed income are interest rates and credit. For the last 10 years, it’s been relatively easy to generate strong, risk-adjusted returns owning either in size, but that’s not the case today.
Over the prior 10 years, whether you were invested in growth-sensitive assets like high-yield emerging markets or securitized securities, spreads have compressed meaningfully. Yields on long-duration Treasuries have also fallen. Investors have generated very strong capital gains over the prior 10 years.
That is likely not going to be the case over the next 10 years, especially with the backdrop that the Federal Reserve is in the process of continuing to raise rates and reduce their active $4.4 trillion balance sheet.
Income investors should focus now on moving more toward a credit barbell strategy, instead of concentrating purely in credit exposure or purely in duration. You reduce your concentrated drawdown risk, you can take advantage of the negative correlation that plays out typically between Treasuries and high yield, and you can build a much more liquid portfolio that should weather potential volatility at some point in the future.
We get lots of questions: “Why would you hold so many Treasuries in the context that the Fed and other central banks are potentially going to raise rates in the next 12 to 18 months?”
Eventually, when the Fed continues to raise rates for the fifth, potentially sixth or seventh time next year, we feel that it will eventually slow the economy, and the key risk to manage is growth risk, not duration. If capital market spread volatility comes back, the large allocation to US Treasuries is the offset which provides the negative correlation to owning credit risk. That is the protection that should offset potential volatility in the future if credit spreads do widen.
For income-oriented investors, the credit barbell strategy is the most efficient way to generate income over the course of an investment cycle. It’s extremely important today because of where valuations are and the changes that are potentially taking place.
It’s a very liquid portfolio. We can play offense if dislocations happen either within or across sectors. So improving your liquidity, moving up in credit quality, insuring that you don’t have large, concentrated growth exposures if stress hits the capital markets, is very important today.
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.
Article by Matthew Sheridan, Alliance Bernstein