Q: How would you describe the current global fixed income landscape and what are the key risks and opportunities you see ahead?
A: Currently, I believe the global landscape for fixed income investors is relatively positive. All-in yields remain above long-term average levels, which is attracting consistent weekly inflows into both U.S. and Euro investment-grade corporate bonds. This is happening despite credit spreads being near decade-tight levels, as the attractive all-in yield is the main draw. Consequently, technical factors are very strong and are supporting corporate spreads.
Additionally, when you consider the impact on total returns during periods when many central banks are in a rate-cutting cycle, fixed income investors generally experience excess returns over cash.
It’s also important to understand why central banks are easing monetary policy. This time, it’s not due to a market shock like a significant credit event in the housing market. Instead, they are easing policy from tight levels because inflation has fallen from high levels and the growth is softening but not collapsing in many economies. In this environment, you could see sovereign yields move lower while credit spreads remain supported at these tighter levels.
Q: What’s your outlook on interest rates over the next 12–18 months, particularly in Australia and globally?
A: When considering the outlook for interest rates, it’s important to differentiate between various segments of the yield curve.
For the front end of the curve, with central banks continue to are easing policy rates, we expect yields at the front-end of curves to move lower. In Australia, this process is likely to be slower however. The Reserve Bank of Australia (RBA) responded to high inflation with a less aggressive hiking cycle compared to other central banks like the Reserve Bank of New Zealand (RBNZ), which hiked rates more aggressively. Consequently, the RBNZ has cut more quickly during their easing cycle. In contrast, the RBA’s shallower hiking cycle suggests they will be slower to react, likely implementing one to two more rate cuts over the coming quarters. This would bring rates to a rough estimate of neutral levels, or around 3-3.25%, by mid-next year.
This outlook can be positive for the front end of the yield curve, although much of this easing has already been priced in. Meanwhile, the back end of the Australian yield curve will be influenced by both domestic and global factors, particularly U.S. yields, which could see volatility on the back of fiscal concerns and higher inflation volatility.
Australia’s more constrained fiscal policy, with a lower fiscal deficit compared to the U.S., is a positive factor. Any reallocation from investors out of the U.S. to those with higher credit quality, like Australia, could lead to Australian back-end yields outperforming. We are favourable towards holding Australian duration at the back end for our full benchmark accounts, as we expect it to perform well on a cross-market basis.
Looking beyond Australia, we forecast six more rate cuts by the U.S. Federal Reserve into next year—two more this year and four next year. This is more aggressive than current market expectations, which anticipate about four to five cuts. We foresee a quicker cutting cycle and a lower terminal rate for the Fed.
We prefer owning duration at the front end of the U.S. curve, but we are more conservative about the back end. The Fed is cutting rates while inflation remains above target, which suggests a higher inflation risk premium at the back end of the U.S. curve.
In Europe, the European Central Bank (ECB) is currently at a broad measure of their neutral rate of 2%. However, there are downside risks to inflation going into next year. With inflation reaching the target in Europe, we see risks skewed to it falling below target next year. Thus the ECB may need to cut rates again, which is not currently priced in by markets.
Q: How are geopolitical tensions and inflationary pressures shaping fixed income strategies today?
A: Geopolitical events are increasingly frequent these days, with many originating from the U.S. and the ongoing conflict between Ukraine and Russia. This rise in geopolitical risks is leading to greater market volatility, which can be advantageous for active investors like AB. Such volatility creates opportunities and market dislocations that can be exploited.
Markets often overreact to geopolitical risks. A notable example is the “TACO” trade—Trump Always Chickens Out. This refers to instances where former President Trump would announce tariff increases, only to later reduce them as a negotiation tactic or upon realizing the potential harm to the U.S. economy.
These geopolitical risks are likely to persist given the current U.S. administration and global tensions. From a volatility perspective, this provides AB with additional opportunities to take active positions. The most significant impact is seen in high-interest rate volatility.
In contrast, credit spreads have not experienced the same level of volatility due to strong investor demand for credit globally. We see significant opportunities in the interest rate market’s volatility. However, the credit market remains attractive, especially in higher-quality investment-grade credit. We prefer owning high-quality investment-grade credit, particularly at the front end of the curve, where we can benefit from lower spread duration. Simultaneously, we maintain some interest rate risk to capitalize on potential central bank rate cuts that exceed expectations.
Q: How does the AB Dynamic Global Fixed Income Fund position itself in volatile markets?
A: The Fund primarily owns duration at the front end of the yield curve, as we look to exposed to drivers of duration more from monetary policy, as opposed to additional risks further out the curve.
In terms of credit, while credit spreads are tight relative to long term average levels, there remains a strong case for owning shorter dated, higher quality sectors. We don’t believe now is the time to be reaching for additional yield in as strategy such as this for meaningful high yield risk or lower tranches of securitized debt.
We like owning U.S. securitized sectors, such as agency mortgage-backed securities (MBS) and asset-backed securities (ABS) in prime issuance only. We avoid subprime auto loans and recent headline illustrate some of the risks this subsector presents. Additionally, we like modest exposure to collateralized loan obligations (CLOs) and credit risk transfer (CRT) securities. These offer additional spread due to their complexity, and the CLO market offers strong credit enhancements in the top tranches that we invest in.
In the credit market, we prefer investment-grade (IG) credit. In European credit, we are seeing strong inflows and demand, which is positive. On the supply side, there has been relatively low net supply, and we have not observed the M&A activity in the corporate space, that you usually experience at this stage of the market cycle. The fundamental outlook for Germany is improving due to a significant fiscal expansion the recently announced infrastructure and defense funds. This structural change in fiscal policy is expected to support growth, particularly in utilities and infrastructure projects, as well as defence related industries.
Regarding emerging markets (EM), we prefer to maintain a diversified approach due to their inherent volatility. We focus on multinational issuers with revenue sources beyond their home countries. For domestic issuers, we favour those with quasi-sovereign links to the government, providing an implicit backing and ensuring credit quality.
Q: What role does duration management play in your current strategy?
A: When we think about duration management, we generally prefer to own duration in the front end of the yield curve for this strategy. We still believe that negative correlations between credit and duration holds more often then not, especially when inflation is not elevated. The exception was in 2022, when inflation was much higher then today while policy rates were also at close to many of the major developed markets.
Q: How do you balance credit risk and interest rate risk in a multi-sector fixed income portfolio?
A: Similar to the previous question, we believe that there is a negative correlation between credit and interest rates, and incorporating some duration into a multi-sector portfolio can enhance risk-adjusted returns over the investment cycle. The appropriate balance of duration and credit risk will vary based on the portfolio’s investment objectives and risk tolerance. Generally, we find that holding shorter-maturity duration provides a more effective offset to credit risk. However, actively managing both the level and composition of credit and interest rate risk is more crucial than relying solely on the portfolio’s initial structure. Utilizing both fundamental and quantitative analysis supports a more dynamic and effective approach to managing these risks.
Q: How do you manage client expectations during periods of underperformance or market stress?
A: During periods of underperformance or market stress, it is crucial to revisit the investment process and strategies that have proven successful over time. Market stress often presents positive investment opportunities. For instance, during the global financial crisis, there was a significant decline in fixed income performance in 2008 and 2009. However, the years following the crisis were favourable for investments, yielding strong returns that more than compensated for the earlier losses.
The worst action investors can take during stressful periods is to divest and not stay the course. This is a key message we emphasize to our clients. While there will be periods of underperformance, it is essential for a fund to demonstrate its ability to outperform over the long term. At AB, we leverage both quantitative and fundamental analysis, believing that this dual approach enhances performance throughout the whole investment cycle. Additionally, we are investing in technology that has improved the efficiency and identification of opportunities in the fixed income market.
Q: Are there any emerging trends or innovations in fixed income investing that you’re particularly excited about?
A: A relatively new trend that is gaining traction is portfolio trading. This allows an investor to send a portfolio of orders—such as 200 individual bonds—to one or two brokers, who will then price them all as a single unit. This development enables managers to execute large portfolio trades more efficiently and often in a more cost-effective manner. This change has been observed over the past few years and is becoming increasingly attractive and popular, particularly in the US and European corporate markets.
Additionally, of course there is the use of AI technology, that is enhancing the effectiveness of research analysts and improving various aspects of the investment process. This technology not only saves time but also can generate additional sources of alpha.
If you would like to learn more about this topic, or have a conversation directly with Nick Sanders, please get in touch.
