Bonds: It is time to fix your fixed income

Fixed income 18 Oct 2023 4 min read
Dr. Martin Wiethüchter
Co-Head Global Fixed Income Investment Specialist Group, UBS Asset Management

Following a series of sharp and steep interest rate hikes by major Central Banks bond yields have rocketed leading investors to flock to once shunned asset class. According to a recent survey by fund research firm Morningstar, new money is currently flowing mainly into fixed income funds. The outlook for the asset class is positive, with most asset managers pointing to new opportunities. Some are even convinced that the yield potential of bonds compared to equities has never been higher in the last 10 years. After all who can resist higher yields with lower risk.

Interest rate situation speaks for longer duration

Some central banks have again raised key interest rates (European Central Bank, Riksbank, Norges Bank), while others have paused (Federal Reserve, Bank of England, Swiss National Bank). The most important insight coming from all the meetings was that it is too early to speak of "mission accomplished" in the fight against inflation. Although inflation has been trending down towards central banks’ targets for a few months some challenges still remain. Resilience of the US economy has surprised most the year, while recent rise in oil prices is also a headwind.

This has led to a renewed caution on longer-term assets with a sell-off in government bonds pushing yields higher. Moreover, central banks have indicated that interest rates may need to stay higher for longer in order to reduce inflation.

Currently, money market investments generally offer yields that exceed those of 10-year government bonds, but further rate hikes are no longer priced in. Why should investors invest in longer-term bonds at lower yields?

Even if these longer-term yields are slightly lower than money market yields, nominal yields are likely to fall again in the coming year.

The view is based on two premises:

  • First, we expect growth to slow further due to tight monetary policy.
  • Second, despite the recent rise in oil prices, we expect inflation to continue to fall.

We therefore believe that high interest rates will be short-lived as the tightening cycle of central banks is likely to end soon. As soon as expectations move towards a subsequent interest rate cut, lower interest rates can be foreseen again leading to price gains.

Duration key to bond total return

U.S. Treasury total return on 1% rate cut

Graph showing coupon income, capital gain, and total return of U.S. Treasuries over 3 months, 10 years, and 30 years. The coupons move from zero to 3.68% to 3.56%, the capital gain from 4.82% to 8.05% to 18.32%, resulting in a total return of 4.82% for 3 months, 11.73% for 10 years and 21.88% for 30 years

For illustrative purposes only. Source: UBS AM, Bloomberg Finance L.P., data as at August 29, 2023.
Note: The assumption is a continuous parallel interest rate shift of 100 basis points down the entire curve and a reinvestment of the realized total return in each quarter for 3-month cash.

Calculation model: FIHZ function at Bloomberg. Coupon income corresponds to coupon payments actually made based on existing 10- and 30-year bonds. No other factors are taken into account in this presentation.

The chart, based on a model calculation, clearly shows that bonds generate substantial capital gains when interest rates are cut. Money market investments cannot compete in such an environment, especially given the reinvestment risk of funds at a lower interest rate. The following rule applies here: The longer the duration, the higher the price gains.

Historical data also shows that attractive returns can be achieved with bonds after a cycle of rate hikes. The table below shows US government bond returns over 12 months period after historical interest rate cycles have ended.

Government bond performance (over 12 months after last rate hike)

Last rate hike

Last rate hike

3-5 Year US Treasury Index

3-5 Year US Treasury Index

5-7 Year US Treasury Index

5-7 Year US Treasury Index

7-10 Year US Treasury Index

7-10 Year US Treasury Index

Last rate hike

May 2000

3-5 Year US Treasury Index

+11.7%

5-7 Year US Treasury Index

+12.6%

7-10 Year US Treasury Index

+12.6%

Last rate hike

June 2006

3-5 Year US Treasury Index

+5.4%

5-7 Year US Treasury Index

+5.7%

7-10 Year US Treasury Index

+5.5%

Last rate hike

December 2018

3-5 Year US Treasury Index

+5.2%

5-7 Year US Treasury Index

+6.7%

7-10 Year US Treasury Index

+8.4%

Source: Bloomberg Finance LP as at August 24, 2023

There is a lot to be said for corporate bonds.

This favorable outlook also applies to corporate bonds for two main reasons:

  • Central banks across the globe are approaching the conclusion of one of the most aggressive tightening cycles on record.
  • This marks a significant milestone for fixed income markets, and a golden entry point for investment
  • Investment grade corporate yields are at the highest level since the global financial crisis
  • Analysis of fundamental corporate figures indicate that corporates currently are relatively solid

Conclusion:

The end of interest rate hikes by central banks is in sight. Investors have an opportunity to achieve attractive returns with investment grade bonds. All in yields yields are at attractive levels and the expected interest rate cuts offer potential capital gains.

UBS Asset Management has the expertise to find the right solutions for investors in this favorable fixed income enviromnent.

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