Fixed income opportunities after COVID-19

The pandemic-induced recession is over and we are beginning to see early signs of economic recovery. Where does Kevin Zhao, Head of Global Sovereign and Currency, Fixed Income, see value in the current environment?

02 Jul 2020

Kevin Zhao, Head of Global Sovereign and Currency, Fixed Income

Kevin Zhao is the lead portfolio manager on all active Global Sovereign and Flexible Fixed Income Strategies as well as Active Currency Management. In this role he is responsible for all investment decisions taken for and implemented in these strategies. He is a member of the Fixed Income Investment Forum, and joined UBS Asset Management in 2011.

Financial markets are beginning to see signs of economic recovery. Which segments of the fixed income markets are likely to benefit from further price appreciation and how is the strategy positioned to take advantage?

Indeed, financial markets have significantly recovered a large portion of the losses suffered in March as a result of massive and well-timed policy support. Admittedly, the economic damage from government-imposed lockdowns in various countries across the globe has been severe and will likely linger for several years to come. That said, if history is anything to go by, financial markets have often been quick to anticipate economic recoveries by reacting to timely policy responses. Of course, exuberance on the part of market participants could be short-lived if there is a second forced lockdown or if governments and central banks withdraw policy support schemes prematurely in the months and years ahead.

We like high quality corporate bonds, especially from issuers outside of the hospitality, travel and leisure sectors.

We also believe that emerging market (EM) bonds issued by countries with low external debt and subdued inflation will do very well as we expect central banks in major economies to maintain ultra-low interest rates for an extended period of time.

The European Central Bank has launched a review of its monetary policy. Which changes can investors expect and what might be the implications for fixed income markets?

One major benefit of the UBS Global Dynamic Bond Strategy is flexibility to seek the best investment opportunities around the world and across the whole fixed income spectrum of asset classes over the medium term while maintaining average investment grade quality, diversification and good liquidity.

In recent years, the UBS Global Dynamic Bond Strategy and other flexible bond strategies we manage have been positioned with long duration in the US, New Zealand and Canada and short duration in bond markets such as Japan and Germany, where yields have essentially hit the effective lower bound (ELB).

Additionally, in the UK we currently have short duration and a bias to yield curve steepening because bond yields have essentially reached the ELB just above zero, while budget deficits are expected to balloon with the country’s debt stock recently eclipsing 100% of its GDP. The high level of debt will likely result in elevated risk premium further out on the yield curve. That's despite the Bank of England being likely to maintain the current 0.1% base rate for the next few years because the UK depends on foreign investors to finance its twin deficits.

On the other hand, we maintain substantial long duration exposures to China, India and Mexico where central banks have ample room to cut policy rates in the next one to two years, especially if there is a second wave of infections.

Investors are not getting paid much today to hold high quality sovereign and corporate bonds. What are your expectations for interest rates across developing markets in 2H20?

That is right and to make matters worse, there is a distinct possibility that investors in high quality sovereign bonds may be exposed to the tail risk of major capital losses, should inflation unexpectedly rise sharply as a result of massive monetary and fiscal stimulus as well as supply chain disruption.

We expect bond yields in developed markets to be rangebound because of zero or negative interest rate policies by central banks and continued large scale asset purchases. This is despite expected large bond issuance to finance government fiscal support measures. Consequently, we expect to be underweight government bonds where yields are very close to the ELB and maintain a diversified basket of high quality corporate, securitized and emerging market bonds. Further, we plan to take on partial tail risk hedges as we seek tactical and relative value opportunities in low yielding developed bond markets.

In our view, another attractive market opportunity is inflation-linked bonds in the US and New Zealand. The reason is two-fold: Firstly, breakeven inflation over the next 10 years in each of these economies is significantly below the respective central bank’s inflation target of 2%. Secondly, realized inflation in both of these countries has been well below historical averages. We believe central banks in the US and New Zealand are committed to attaining their medium-term inflation targets. Also, they each have a stellar track record of delivering on their inflation targets over the past 20 years. In contrast, other central banks such as Bank of Japan, European Central Bank, Swiss National Bank, Reserve Bank of Australia and Sweden’s central bank have consistently failed to meet their inflation targets.

Stay tuned for the rest of this series of interviews sharing Kevin's insights on global flexible fixed income investing.

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