The force awakens in fixed income

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. Here, our fixed income team discuss the potential implications for returns in a post-hiking cycle world.  

Nearly two years on from the first policy rate hikes, the global economy is normalising. Soaring inflation has peaked, and continues to trend downwards more convincingly towards target, as demonstrated by Figure 1. This provides much needed relief to central bankers across the globe, who are becoming increasingly confident that the monetary tightening first administered over a year ago is taking effect on inflation. 

Figure 1: % CPI change YoY

Source: UBS, Bloomberg Finance L.P. Data as at September-end 2023

Where do we go from here? As inflation continues to moderate, the likelihood of additional policy rate hikes decreases. Both economist forecasts and market expectations (see Figure 2) imply that policy rates are either at, or very close to their peak. This change in policy stance opens the next chapter in fixed income. 

Figure 2: Current and 6M forward policy rates (%)

Source: UBS Asset Management, Bloomberg Finance L.P. Data as at July-end 2023.

Higher policy rates across the globe have driven bond yields to decade-highs. As shown in Figure 3, yields in most sectors are sitting comfortably within the 90^th percentile of levels since 2007. Higher yields provide investors with some insulation against the potential negative impact of further rate increases or credit spread widening. In fact, the impact on price return driven by further increases in government bond yields thus far this year has been offset by higher levels of income, which have been the primary driver of returns.

Figure 3: Global yields at decade-highs

Source: UBS Asset Management, Bloomberg Finance L.P. Data as at end-October 2023.

While interest rate volatility remains elevated, higher yields are likely to continue to support fixed income returns, particularly as it appears global central banks are approaching the end of monetary policy tightening. With attractive upside potential, healthy downside protection and an enticing entry point, there is a golden opportunity for investors in fixed income. 

Curve inversion in many fixed income markets means yields are highest and therefore most attractive at the front-end of the curve. However, with rate hikes increasingly in the rear-view mirror, investors should look ahead towards a post-hiking cycle environment and therefore diversify exposure further out the curve, where prospective capital gains are greater in the event of declining interest rates. Adding exposure in advance is critical, given long-end rates have historically decreased sharply following the conclusion of rate hiking cycles, as illustrated by Figure 4.

Figure 4: Yields fall swiftly once central banks stop hiking

Source: Bloomberg Finance L.P. Data as at August 2023.

History indicates that the period immediately after hiking cycles conclude can be lucrative for bond returns. As Figure 5 demonstrates, this is particularly evident in longer-dated bonds where duration is a stronger driver of capital gains. Once interest rates start to decline, the total return from holding a longer-dated, longer-duration bond over a fixed period is significantly greater than the total return from repeatedly re-investing in short-dated, short-duration bonds.

Figure 5: Performance of US Treasuries 12 months immediately after the last rate hike in the cycle

Source: Bloomberg Finance L.P., ICE BofA. Data as at 21 September 2023. N.B. performance is the total return of the relevant ICE BofA US Treasury index in the 12 months following the date of the last rate hike in a cycle.

While the front-end is attractive on a yield-basis, investors should be mindful of other sources of total return, namely duration and credit spreads: diversify further out the curve to benefit from duration-driven capital gains given the historical performance of fixed income markets coming out of rate hiking cycles.