Riders on the storm Fixed income investing for a rising rate world

UBS Asset Management For professional/institutional investors only October 2018

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Global bond yields troughed in mid-2016, and have been rising ever since. This reversal has long been predicted, often prematurely, and represents a market development that many commentators and investors have dreaded. We understand these fears, but feel that they are often misplaced. Such trepidation stems from the expectation of imminent and steep price declines, and it disregards the other sources of total return that are available from fixed income markets.

At UBS, we believe that it is critical for investors and financial advisors to have a deep understanding of the various drivers of total return within the fixed income asset class. It is even more critical at this particular juncture, as we are confronted by a rising interest rate environment. Those armed with such an understanding can approach their asset allocation and portfolio construction responsibilities in a confident and

informed manner, laying to one side any misconceptions about the death of a mythical bull market in bonds. In our view, the rise in global bond yields from their extreme lows is nothing to be feared. Rather, the slow dismantling of a decade-long regime of financial repression should be a very welcome development for all investors, particularly for those that are dependent upon income.

Jeff Grow Executive Director Senior Portfolio Manager Fixed Income

Executive Summary Bonds deliver two forms of returns for investors:

income returns and capital returns.

Income returns are more stable and predictable, providing the foundation for total return expectations.

A rising interest rate environment will deliver higher income returns for investors over time.

In consequence, bond prices will fall – temporarily – as the existing stock of debt adjusts to higher market yields.

Investors should actively manage these trade-offs between income and price returns, in the short run.

In the longer run, however, the total return that is delivered by bonds depends almost exclusively on income sources.

We welcome this turn in the cycle, as it improves the total return outlook for bond investors over the medium term.

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Sources of total returnWhen approaching fixed income, we always think in a total return context. As with most other asset classes, bonds deliver two forms of return to investors: those of an income nature, and those of a capital nature. The former are relatively stable and predictable, and provide the core foundation for bond market returns across any investment horizon. The latter, in contrast, are subject to inherent uncertainty and volatility, particularly in the short run. However, as we shall explore, capital returns tend to fade as a driver of the total returns that are delivered by fixed income in the long run.

Approaching the asset class using this kind of conceptual framework helps to isolate each of the individual drivers

of total return. Once isolated, deeper analysis can then be conducted into each driver, in order to properly determine the available opportunities, and the associated risks, within that sub-set. As the individual constituents are better comprehended, the relative contributions of income and capital towards the total return from global fixed income can be properly appraised. Total return analysis depends upon the consideration of a multitude of factors, and no single portfolio metric, such as option-adjusted duration or yield to maturity, will neatly represent the ultimate source of truth, ex-post.

Figure 1. A conceptual framework for total return analysis

Total return

Income returns Capital returns

Coupon Currency hedging Price Pay-down

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Income returns

For an asset class that is called fixed income, there is often surprisingly little focus on income as a source of total return.

This is a key area of neglect in the debate, in our view. Over the medium- to longer-term, income provides the lion's share of the total return that is available from the bond market. It is for this reason that we commence our discussion with the contribution towards total return that comes from the income side.

In a global bond portfolio, income returns derive from two key sources:

1. Regular accrual of coupon payments (interest); and

2. Periodic cash flows that arise from hedging foreign currency bonds back into an investor's base currency.

Throughout this paper, we will frequently reference the Bloomberg Barclays Global Aggregate Index. This is one of the most widely followed benchmarks for investment grade fixed income, representing nearly 22,000 individual securities, in over 20 currencies. The analytics available from this index represent a good approximation of the core characteristics of a standard global fixed income portfolio.

CouponsAt the end of September 2018, the average coupon rate within the Bloomberg Barclays Global Aggregate Index was 2.67%. This represents the average interest rate being paid on over USD 50 trillion of outstanding debt. It forms the foundation for any discussion on the total returns that might be expected from global fixed income.

Chart 1 depicts the distribution of coupon rates within the Bloomberg Barclays Global Aggregate Index, and also captures the shift in this distribution over the past decade. It is undeniable that investment grade coupon rates have fallen in the past ten years. The average coupon rate has declined from 4.43% to 2.67%, and the distribution has shifted clearly to the left. This development broadly reflects the considerable easing of monetary conditions across the major economies since the global financial crisis. For investors with a total return focus, this development has not been favourable, delivering a progressively lower income stream over time, at least when measured in nominal terms.

Chart 1: Coupon distribution within the Global Aggregate Index

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Source: UBS; Bloomberg Finance LP; Barclays. Data as at 30 September 2018.

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Chart 2: Coupon rates within the Global Aggregate Index

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Source: UBS; Bloomberg Finance LP; Barclays. Data as at 30 September 2018.

Chart 2 digs a little deeper, and shows the average coupon rate of the major markets within the Bloomberg Barclays Global Aggregate Index over time. The downward trend in average coupon rates is evident, across all markets. What is noteworthy, however, is that the average coupon rate in all markets is still positive, even for regions where central bank policy rates are currently negative. From a total return perspective, this means that investors and financial advisors can rely upon coupon income to make a positive contribution towards global fixed income returns, across all sectors and all currencies. The quantum of this coupon income provides the foundation for the expected total returns from a bond portfolio in the medium- to long-term. Critically, it also provides a cushion with which that portfolio can absorb market volatility in the short term. It is important to recognise these two points. In our observation, little of the popular discussion on prospective returns from global bonds ever mentions coupon income as a key consideration or a core building block in the portfolio construction process.

While coupon rates may look optically low in the current environment, this will shift as global central banks slowly remove their excessive monetary accommodation. As higher market yields translate into higher coupon rates on newly-issued debt, the distribution in Chart 1 will start to shift towards the right. We have seen this already in the US bond market. Fixed income investors stand to reap the benefits of these higher coupon rates into the future. The global tide has now turned, and it has turned in the favour of income-seeking investors. This is a very positive development, in our view.

Currency HedgingInvestors in global fixed income invariably need to deal with foreign exchange risk, in one form or another. How they elect to approach this, and which base currency is involved, are critical issues for portfolio construction. The question of active currency management within a global bond portfolio is a whole topic unto itself, but at UBS we believe strongly that any assumption of foreign exchange risk needs to be a conscious investment decision. It should come with its own risk budget, risk management policies, and return expectations. Unwittingly taking foreign exchange risk as a by-product of the currencies into which a fixed income asset allocation has been made is highly undesirable, and dangerous in our view.

Using forward foreign exchange contracts to hedge out currency risk simply entails selling and repurchasing the investor's base currency over the life of the foreign investment. Hedges will generally be implemented for a short tenor, even if the underlying asset reflects a longer investment horizon (e.g. a 10-year bond). Progressively rolling forward foreign exchange contracts will generate capital gains or losses for the bond portfolio in the short term. However, even though these activities are essentially

"capital" in nature, we find that currency hedging sits more comfortably on the "income" side of our analytical framework. The cash flows generated here are regular, and relatively predictable, similar to those that are associated with coupons. The returns that are generated by foreign exchange hedging essentially just reflect the costs of borrowing and lending in different currencies, and approximate the short-term interest rate differentials that exist between markets.

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Chart 3: Impact of hedging currency risk in the Global Aggregate Index

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The hedged returns on the Bloomberg Barclays Global Aggregate Index are available for a wide range of currencies. Analysis of this data allows investors and financial advisors to isolate the currency effects for completely hedging a global fixed income portfolio. Chart 3 depicts these returns for a selected group of major currencies, over the 12 months ended September 2018.

In an environment where the average coupon rate from investment grade global fixed income was just 2.67%, as shown earlier in Chart 1, the overlay of these currency

hedging decisions can make a considerable difference to an investor's return expectations. Unlike coupon income, where the contribution towards total return is universally positive, currency hedging can deliver either a positive or a negative contribution for investors. The direction of this return depends upon the base currency of the investor, and the markets into which capital has been deployed.

We can make two broad observations here:

– For investors whose base currency is from one of the higher-yielding markets (e.g. dollar bloc countries), currency hedging is generally additive to coupon returns. These investors will be compensated for the opportunity costs of forsaking their higher-yielding domestic markets to allocate capital abroad. Summing together the income streams generated by coupons and currency hedging, such investors can expect a contribution towards total return of between 3-4%. This provides a strong foundation from which a fully-hedged global bond portfolio can absorb any market volatility that stems from return drivers that are of a capital nature.

– For European and Japanese investors, the picture is very different. Here, the costs of currency hedging can be prohibitive. A policy of 100% hedging effectively translates foreign income back into a negative-yielding environment, offsetting the yield pick-up. For this cohort of investors, currency hedging detracts from coupon returns, reducing the overall contribution from income sources by over 1%. This, in turn, provides a much thinner cushion from which a fully-hedged global bond portfolio can absorb market volatility.

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Capital returnsUnlike cash or bank deposits, the value of fixed income instruments can change on a daily basis. This will generate capital returns (gains or losses) for investors, as bond holdings are marked to market. There is nothing unique about this; changes in bond valuations simply reflect the collective actions of fixed income investors, reacting to the ebb and flow of demand and supply, and adjusting their expectations, as and when confronted with new information.

For a global bond portfolio, capital returns derive from two key sources:

1. Daily valuation effects on bond prices, stemming from changes in market yields; and

2. Irregular valuation effects that can result from the early return of capital to investors (so-called "pay-downs"), before a bond's contractual maturity.

Price ReturnsThis is the area that attracts most of the discussion, and fear, about investing in fixed income. It is well known and understood that bond prices have an inverse mathematical relationship with yields. As bond yields rise, bond prices will fall, and vice versa. In an environment of rising global

yields, we observe that the fear of prospective capital losses from bonds tends to drive a lot of the market commentary, even if much of this analysis is superficial at best, and ill-informed at worst.

"Price return" is the terminology used by index providers, such as Bloomberg and others, to reflect the valuation effects of changing yields on bond prices. Such valuation effects may be realised or unrealised by investors, depending on whether they are actively trading in the bond market on any given day. In terms of its contribution towards total returns, the price return can make either a positive or a negative contribution, depending upon the direction of market movements.

While bond prices have an equal capacity to go up as well as down, the debate about price returns is rarely even-handed. At UBS, we observe much commentary that often seeks to alarm investors and financial advisors by pointing to the ever-rising sensitivity of bond prices to yield movements, as reflected by the steady increase in portfolio duration over the past decade. Chart 4 plots the relationship between yield and duration for the Bloomberg Barclays Global Aggregate Index since the inception of that benchmark.

Chart 4: Key characteristics of the Global Aggregate Index

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Source: UBS; Bloomberg Finance LP; Barclays. Data as at 30 September 2018.

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Chart 5: Modified duration within the Global Aggregate Index

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Source: UBS; Bloomberg Finance LP; Barclays. Data as at 30 September 2018.

Quantifying and managing price risk is one of the most important things to get right when investing in a global fixed income portfolio. However, it is also one of the most poorly articulated subjects. Critics of traditional fixed income often seize on this duration metric as a harbinger of impending catastrophe. All other things being equal, a 1% rise in global bond yields would inflict a price decline of around 7% to an investor that used this index as a reference point. That 7 years of modified duration, however, conceals very different price risks across regions.

Chart 5 illustrates the point, by showing that bonds denominated in USD and EUR, the two largest constituents of the Bloomberg Barclays Global Aggregate Index, have a lesser price sensitivity than the global investment grade universe as a whole. In contrast, it is in the JPY and GBP markets where we observe the highest price risks, as both Japan and the UK have a much longer duration than the overall index.

While the mathematics connecting bond prices and duration are not in dispute, we would caution against taking things at face value, or jumping to conclusions. All other things are not equal. The duration contributions to the Bloomberg Barclays Global Aggregate Index are distributed across various regions, all of which are at different points in their policy cycles. There is no single world central bank, and no globally synchronised approach to monetary policy. The recent rise in global interest rates has been led by the US Federal Reserve, and followed – in smaller measures – by some other Anglo-Saxon countries. The central banks of continental Europe and Japan do not contemplate tightening monetary policy for some time, and once they are ready to begin the process of normalisation, we might very well expect that the US-led

tightening cycle could be near to its end. These divergent monetary policy impulses should make clear that regional bond markets do not all move with a beta of one.

Similarly, yield curves very rarely shift in a parallel fashion. As central banks tighten policy, we would normally expect to observe a flattening trend in the yield curve. Short-dated bonds will remain the most sensitive to central bank policy changes, but equally they have a lower-than-average duration (price risk) relative to their longer-dated counterparts. Longer-dated yields will tend to move with more secular thematics, such as the medium-term outlook for inflation and economic growth. As relative prices adjust along the yield curve, this will generate varying degrees of price returns, which are not likely to be uniform. We believe that any analysis that refers to the overall risk to a bond index or portfolio, based solely on the metric of duration, loses many of the nuances here, and presents an incomplete picture.

How far bond prices can move, particularly in a downward fashion, is also an area where headlines tend to only scrape the surface. Duration is a key metric of price risk, but bond prices do not form in a vacuum. They remain inextricably anchored by the complex relationship between prevailing market yields and the coupon rates that exist on outstanding debt. We demonstrated earlier that coupon rates change relatively slowly, and will tend to lag movements in market yields, in both directions. As investors' return requirements change, bond prices will adjust to effectively equalise the expected returns between the outstanding stock of coupon-bearing debt and prevailing market yields. This adjustment will push bond prices either above or below their par value for a period of time, although all bond prices will ultimately return to this anchor point in the long-run (absent any defaults).

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Chart 6: Bond Prices within the Global Aggregate Index

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Source: UBS; Bloomberg Finance LP; Barclays. Data as at 30 September 2018.

There is no decades-old bubble in bond prices here that is waiting to be popped.

Chart 6 puts into context the folklore surrounding the much-vaunted, multi-decade-long, bull market in bond prices. Here, we plot the average bond price within the Bloomberg Barclays Global Aggregate Index, and its major constituent indices, over a long time horizon.

The average bond price for the Bloomberg Barclays Global Aggregate Index has tended to oscillate between 95 and 110, while that for the US Aggregate Index, the largest single constituent, has now returned to its par value. For the US, the average coupon rate and the average market yield are now in alignment, around 3%. For bonds denominated in EUR and JPY, market yields remain below outstanding coupon rates. The mathematical outcome of this situation is for bond prices in those markets to sit above par value. However, even here, we observe that prices are now well off their highs, as the European Central

Bank and the Bank of Japan have both slowly relaxed the magnitude of their intervention in the bond market.

At the risk of debunking what has seemingly become accepted market wisdom, we find no evidence to support a decades-old bull market in bond prices. While market yields have indeed fallen from 9% in 1990 to just 2% in 2018, this has been accompanied by a similar sharp decline in coupon rates, which fell from 8.9% in 1990 to just 2.7% in 2018. All of the high-coupon bonds of yester-year matured a long time ago, and have since been replaced with lower-coupon substitutes, as we saw earlier in Chart 1. Income returns have been lowered sequentially. Price returns were boosted temporarily, as the average market yield traded below the average coupon rate, but bond prices have already retreated from their highs.

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As investors, we should learn from the lessons of history, but always maintain our focus on the future. Further rises in US bond yields will see the average USD bond price decline below par value, in the short-run. This has happened before, and is the product of a well-understood, and purely mathematical, relationship. Against these prospective negative price returns, newly-issued debt will come with progressively higher coupon rates, boosting the income returns that are available to investors. This is one of many instances where bond investors face a trade-off between capital returns and income returns. It is also why we believe that price returns need to be considered as part of the broader mosaic that is total return investing, and not simply in isolation. To do otherwise means that the interaction between capital returns and income returns can get misconstrued, or overlooked entirely.

Pay-down ReturnsWhile price returns dominate the capital returns that are observable within global fixed income, there are also occasions where capital is returned to investors at a different time, and a different price, to that which might otherwise have been expected. Early repayment of capital in this manner (a "pay-down") is akin to an unplanned, partial sale of bonds before maturity, and belongs on the capital side of our total return framework.

Pay-down returns stem principally from the securitized markets in the US, where borrowers in mortgage-backed

pools have the option to pre-pay their loans, returning capital to investors before the expected life of the bond has been reached. In most instances, this will be because the underlying borrowers have refinanced their loans at lower interest rates, and shifted from higher- to lower-coupon mortgages. The net effect for investors is the partial repayment of their principal, earlier than planned, and at par value. If par value represents a different price to the current market valuation of the securitized bond, there will be a capital impact for the portfolio. Depending upon market conditions, pay-down returns can deliver either positive or negative outcomes to investors. When bonds trade above par value, any unexpected pay-down will generate capital losses for investors; when bonds trade at a discount to par value, capital gains will arise from any unanticipated pay-down.

Chart 7 depicts the impact of pay-downs on the Bloomberg Barclays Global Aggregate Index over time. In any given month, pay-downs deliver an almost negligible impact on total returns, being completely overwhelmed by the steady coupon income that is generated, and the more volatile price returns. However, over time, pay-downs have tended to detract from the total returns that are available to bond investors, particularly when there is a major shift higher in US mortgage refinancing activity. Understanding activity within the mortgage-backed sector can assist investors with managing the downside risks that pay-downs typically present for their total returns.

Chart 7: Pay-down Returns within the Global Aggregate Index

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Source: UBS; Bloomberg Finance LP; Barclays. Data as at 30 September 2018.

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The power of income At UBS, our fixed income portfolio managers deeply understand each of the individual drivers of total return, and strive to use their insights and experience for the benefit of our clients. We look to take advantage of the opportunities, and to control the risks, within each of the key components discussed in this paper: coupon, currency, price, and pay-down. In so doing, we are mindful that bond investors face constant trade-offs, particularly when seeking to balance their aspirations for both income generation and capital preservation.

Our approach is underscored by the fact that income is the key driver of total returns within the bond market, over the long term. Charts 8 and 9 evidence this point by illustrating the outsized contributions that have been made by coupon income, relative to the total returns generated over time by the Bloomberg Barclays US Aggregate Index and the Euro Aggregate Index.

In the short-run, coupon income serves as the core foundation for total returns, making a positive outright contribution, and absorbing the negative price returns that have resulted as bond yields moved higher. Over the longer-run, coupon returns tend to approximate total returns, as most capital-induced volatility fades into the background.

To understand why this is the case, we need to step back from the minutiae of the individual drivers of fixed income for a moment, and to contemplate the economic interests of bond investors. As holders of capital, fixed income investors look to lend it to others for a finite period, but are not willing or able to commit this capital to a single entity in perpetuity, as would an equity investor. As compensation for lending out their capital, bond investors require an economic return, which is represented by a regular stream of coupon income. The capital underlying this loan always belongs to the investor, and must be returned to that investor at an agreed point in time. As such, fixed income tends not to position itself as a "growth asset", for the mere fact that bond investors do not approach the asset class with such a mindset. Rather, they seek to avoid credit defaults, extract a regular income stream from their capital, and to leverage the benefits of compounding interest returns over time.

Meeting the challenges posed by rising ratesWith a mindset that places income squarely as the key element of total return, we approach the prospect of rising global interest rates with perhaps a slightly different perspective than others. Rather than be unnerved at the prospect of declining bond prices, we see that higher bond yields will be translated into higher coupon rates, which will subsequently get translated into higher income returns. This is a positive development for all income-dependent investors over the medium term.

Having this medium-term focus on total return allows our portfolio managers to direct their efforts towards maximising value within each of the key drivers that we have covered in this paper: coupon, currency, price, and pay-down. To do so, first and foremost, requires a commitment to active portfolio management. At UBS, we have experienced portfolio managers, in key locations around the globe, whose daily focus is to deliver performance, and to achieve the total return ambitions of our clients.

Figure 2 illustrates several of the active strategies that we employ in order to pursue the opportunity sets across each of the return drivers that we have explored in this paper.

Chart 8: Returns for the US Aggregate Index

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Chart 9: Returns for the Euro Aggregate Index

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Figure 2. Extracting value in a rising rate environment

Income returns Capital returns

Coupon returns Price returns

Achieve a higher running yield through allocations into: – Investment grade credit – High yield credit – Sovereign credit (Emerging Markets; peripherals)

Increase the sensitivity of coupon payments to rising market rates through allocations into floating-rate notes.

Target client income requirements through a security selection that favours older vintage and higher coupon bonds.

Use derivative contracts to synthetically transform fixed-rate coupons into floating-rate equivalents.

Preserve the real value of coupon income over time through an allocation into inflation-linked securities.

Active management of duration to: – Protect against lower bond prices; – Benefit from higher bond prices.

Active management of price risk across the yield curve to capture: – Flattening opportunities – Steepening opportunities – Relative value anomalies

Active management of credit spreads to: – Capture spread contraction – Hedge against spread widening

Protecting the real value of investors' capital through an allocation into inflation-linked securities.

Leveraging our global presence to deliver insights across markets, and actively trade cross-market spreads.

Currency returns Pay-down returns

Fully hedge investors from higher-yielding base currencies to minimise opportunity costs and supplement income returns.

Consider the appetite for FX risk for investors from lower-yielding base currencies. Is a 100% hedging policy appropriate or desirable? If not, design and implement the most appropriate hedging ratio.

Monitor forward market pricing to anticipate shifts in the prospective currency-hedged returns for different base currencies.

Agree with clients on whether active currency management should be utilised as an independent source of alpha within a global fixed income allocation.

Understand the micro-structure within securitized markets, and what drives the pattern and magnitude of pay-downs.

Employ an active sector allocation strategy that favours securitized bonds when pay-down risks are low, and underweights them as refinancing risks grow.

Identify bonds through active security selection that are priced at, or below, par value, and which can benefit positively from an accelerated pay-down profile.

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Bringing together all of the elements that drive fixed income returns causes us not to fear a rising rate environment. We see this regime shift as beginning to restore the value to be had from global bonds as an asset class, and as a development that should boost total returns over the medium term. Critics may decry the short-term pain of higher yields on bond prices. We believe firmly that these can be defrayed through skilful active management of price risks, and a sharp eye for capturing the higher income opportunities that will eventuate.

The rampaging bond market bull has not been slain by the US Federal Reserve or the end of Quantitative Easing.

Its very existence was, perhaps, as mythical as that of the fabled Minotaur: a creature of reputed common knowledge, but one that was never actually seen! As active investors, we place our faith in hard evidence, not into the stuff of folk-lore. For us, global fixed income remains completely fit-for-purpose, given the unquestioned power of income, over the longer term, to deliver on the total return aspirations of investors. Nothing has changed in this respect, apart from the new dawning reality of steadily increasing income returns. After a decade of financial repression, such a development should be welcomed.

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