By Douglas J. Peebles
When the Fed does eventually start raising interest rates, at AllianceBernstein we don’t expect to see bonds experiencing the dire scenarios of 1981 or 1994. Instead, the 2003–2006 period of slow and measured rate normalization seems more likely. But it’s not a perfect match, and we do see some important investment factors to consider.
The Bad News
We’re later in the credit cycle today than we were in June 2003, when high-yield markets were rebounding from late 2002’s cyclical peaks in high-yield spreads. Today, high yield has already been through several years of strong overall performance. Spreads might narrow further from here, but it would be a more modest compression than we saw in 2003–2006.
Importantly, there is a cautionary tale here about chasing yields. By June 2007, high-yield spreads were at all-time lows — near 240 basis points (bps), with low volatility, high flows and ample issuance, and issuer-friendly structures and lower-quality offerings coming to market easily. Shortly after that, the global financial crisis brought credit carnage: liquidity and issuance dried up, and US high-yield spreads exploded, to nearly 2,000 bps by the fall of 2008.
Today, we’re at or near single-year highs in issuance of CCC-rated bonds and other similarly risky offerings and structures — highs we haven’t seen since … 2006–2007. So, while we still see potential opportunities in credit as a whole, it’s crucial today to be selective and not chase yield.
The Good News
The US yield curve is extremely steep today, particularly the intermediate-long part of the curve. It was steep (roughly 2%) in June 2003, too, when the 10-year US Treasury yield was above 3% and the two-year was around 1%. But today’s “2s–10s spread” is wider — more than 2.5%. And the credit-spread curve is also steep. In other words, we’re seeing attractive opportunities, and, importantly, yield-curve position matters.
All in all, we feel the mid-2000s period provides us with a good guide for what may unfold for bonds in the coming months and years. While high-grade and high-yield bond returns should be more muted, they also shouldn’t resemble the dismal experience of 1994 — let alone the horrendous situation of the early 1980s.
What should investors take away from this? The key message is: Don’t panic! But do pay attention to position. Instead of fearing interest-rate exposure, diversify it and focus on yield-curve position. Add value and risk diversification through credit exposure, but be selective and don’t overreach for yield.
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.
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein.