Investor Note

The global interest rate cycle has been pretty spectacular over the last few quarters. US 10-year yields fell from over 3% at the end of 2018 to below 1.50%. As of month-end October 2019, they were still below 1.70%. German 10-year government bonds are still in negative territory.

Already last year, at the 2018 UBS Reserve Management Seminar, UBS Chairman Axel Weber argued that any normalization in interest rates was unlikely to happen during this cycle and more cycles might be needed. It appears he was right and yields are likely to remain low over the medium to long term. In addition, as we outlined in our last Investor Note, the world’s central banks have become not just the repairmen for the economy but in fact the fire brigade, due to their ability to be more nimble than political decision makers. A major reversal in trade negotiations and a fast recovery would be required to re-initiate the normalization trend interrupted in the last quarter of 2018. But if more trade war-related pain materializes down the road, could central banks be forced to ease even more aggressively? Should the US go into recession next year, could the unthinkable happen and US rates turn negative?

The current investment environment is particularly challenging for fixed income investors who restrict themselves to conservative portfolio allocations. Central banks have historically prioritized liquidity in their portfolios. This creates a preference for highly rated government bonds which can be liquidated at short notice and have tended to perform well in mark-to-market terms in risk-off environments. With a USD share of global FX reserves of above 60%, the fall in US interest rates is particularly painful for reserve managers. Additionally, in Europe, the liquidity situation is more and more deteriorating, in particular in corporate bond markets. While US markets still have positive net supply and more retail activity, EU markets face little net supply and a price-insensitive buyer (for reinvestment purposes) in the form of the ECB which owns almost € 180bn of corporate bonds.

We generally advise that central banks should look to maximize returns subject to meeting their own minimum liquidity requirements. Therefore, if liquidity requirements increase/decrease, risk appetite to earn return from other sources by taking credit or market risk should change accordingly. Over the past years, central banks have mainly extended duration within their fixed income investment framework.

With this strategy reaching its limits, a number of strategies are getting employed to cope with ever-decreasing yields:

1. Ongoing diversification into equities: For a first move into this asset class, most central banks use a flexible phasing of the build-up of their equity exposure, halting or accelerating the equity build up depending on market trends and valuations. We generally advise that central banks that are considering whether to diversify into equities as part of a long-term diversification of their allocation should indeed follow such a phased approach, as market tops are notoriously difficult to time.
2. Unconstrained and flexible range strategies allow for active management along a wide range of bond classes including EM and high yield as well as the use of derivatives. We observe that more and more central banks expand the eligible universe beyond standard benchmarks to give their internal and external managers more freedom in generating alpha. Even for conservative portfolios we see the list of off-benchmark countries (rated BBB- or higher) increasing to allow allocations for example to solid developed economies like New Zealand, but also selected EM exposures to China or Mexico.
   
   More central banks also allow managers to use bond futures and swaps not only for hedging but also for cross-market positions (e.g. long Treasuries/short Bunds) which have the potential to generate alpha. Finally, investment management guidelines are allowing more and more for flexibility in styles for the manager to more actively switch between credit and market risk depending on the point in the cycle. The unconstrained UBS-AM Global Bond Dynamic strategy as well as UBS-AM flexible range strategies like Global Flexible, Euro Flexible and Short-term Flexible fixed income strategies are an option for investors who have expanded beyond benchmark investing and allow the use of derivatives.
3. Yield enhancement strategies for short-term tranches. The chart below maps the typical products at large asset managers like UBS on a continuum that starts at very liquid products with strong capital protection to invest operating funds, then moves to products which are ideal for reserve funds which are expected to be tapped less often, and ends in products for strategic reserves which are not expected to be needed over the investment horizon, which allows for slightly more risk-taking for higher yield potential, and a portfolio duration of 1-5 years. We also added selected EUR-denominated strategies from UBS and their yield-to-maturity as of October 2019 to illustrate the fact that it is currently very difficult to achieve positive yields in strategy categories that are typically used for operating or reserve tranches. Where do we currently see the most interest when it comes to yield enhancement strategies for short-term investments?

Broad range of offerings across various maturity/liquidity spectrums