Kevin Zhao on flexible fixed income strategies

In this latest PM Corner interview, Kevin Zhao focuses on opportunities and changes in global fixed income markets, positioning in the current macro environment and the strategy's main performance drivers.

07 Feb 2020

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


Macro environment / FI markets


Q: Low spreads, negative interest rates and stretched valuations are complicating the life of fixed income investors. How can investors navigate given these challenging market conditions?

A: Lack of yields doesn’t mean lack of opportunities. That's why we advise investors to go global and be more flexible. Bonds almost everywhere performed extremely well in 2019 as central bank intervention continued to support prices. At one point a staggering $14 trillion of bonds traded with a negative yield (prices move inversely to yield). But in 2020 it is unlikely that all bonds can match the returns experienced last year, and generating good returns will require a more selective approach. Investors must also pay attention to the impact of tail risks as yields have fallen significantly and the sensitivity of bonds to interest movements has increased. A sound approach will be to balance the resilience of the portfolio to unexpected exogenous shocks, while maintaining the flexibility to profit from any market repricing.

With this philosophy in mind we have broadened our horizons from G7 developed country bond markets that traditionallyformed the vast majority of investors' global bond holdings. These countries are typically characterized by very low real yields and actually account for the vast majority of bonds that are trading at negative yields. Instead our investment horizon is focused on the G20, which includes several countries such as China and Brazil, typically thought of as emerging markets. G20 could be labelled "the New Global" because it is a much better reflection of the global economy today.

Q: Where do you see the best opportunities in fixed income markets globally in 2020?

A: For 2020, we focus on relative values and monetary policy changes outside of the G7 as the Fed, ECB and BoJ are likely to keep policy unchanged for the next few months at the least. However, central banks in Canada, Australia and New Zealand are more likely to cut rates in the developed world. At the same time we see ample opportunities in some emerging markets where growth and inflationary pressures have been weak and their central banks still have plenty of room to cut rates. Examples include Mexico, China and to a lesser extent in South Africa, Russia, India and Turkey. We have recently moved some of our holdings from investment grade corporates to investment grade securitized bonds in the US. Spreads are slightly wider for similar ratings, while sensitivity to a recession or rising defaults is lower.

Q: 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?

A: The ECB policy review is useful for the new President Lagarde to bridge the difference between the hawks (mostly from the surplus northern countries) and doves (mainly deficit countries) in the Governing Council (GC), and may be able to establish a set of common analytical frameworks for the GC to make their future policy decisions. Although the review is unlikely to trigger a meaningful change in the ECB's policy responses this year, we do believe that the ECB policy rate has reached its effective lower bound (ELB). We expect a diminishing impact, for the economy or financial markets at large, of any further cuts in the deposit rate or increase in asset purchases. In our view macro-economic policies should shift to fiscal stimulus by countries with fiscal and current surpluses such as Germany and the Netherlands.

As it stands the Stability and Growth Pack (SGP) is deflationary and one of the major causes (along with demographics and technology) for falling inflation and interest rates. The twin surpluses (current account and budget) have created massive excess savings for the Eurozone. This in turn exacerbates global imbalances and pushes down the Eurozone’s equilibrium interest rate, where policy balances the demand for money, well below zero. As a result, the Eurozone monetary policy stance is actually neither accommodative nor reflationary, in spite of a historical low ECB rate of -50bps and large scale asset purchases. The solution is a mandatory shift for countries with twin surpluses to run budget deficits in excess of nominal GDP growth for a couple years and until Eurozone core inflation meets the ECB target of 2%. In addition, a Eurozone revitalisation investment vehicle, primarily financed and owned by the surplus countries, could be a ground-breaking policy to recycle the excess saving into long-term productivity enhancing investment projects.

Q: What are the main risks for fixed income investors and how are you positioned to hedge them?

A: If developed market economic growth in 2020 proves significantly higher than consensus, then this might pose a challenge for fixed income investors. For example, an unexpected and significant fiscal stimulus or higher wages and inflation could push bond yields higher, resulting in negative total returns for index-based bond investors. The most effective hedge is to own at least some inflation linked bonds and to under-weigh countries where fiscal policies are turning very simulative. There are also downside risks to the global economy; for example an unexpected recession in the US or certain outcomes in the November election. And recent events demonstrate that the risks posed by more left-field events such as a renewed trade war, escalation of Middle East tensions or disruption to travel. In these more extreme events the best hedges are likely to be 30 year US Treasuries and bonds issued by countries with limited scope for fiscal expansion, for example Canada.

Sub asset classes/markets/currencies

Q: What is your current view on government bonds? Which countries do you favor and why?

A: We see US bonds yields in a range of 1.00-2.25% in the next 6-12 months and continue to focus on cross-country opportunities. We are long fixed income in US, China, Mexico, New Zealand, India, South Africa and Canada vs short in Switzerland, Japan, Germany, UK and Hungary/Poland. We see the long end US bond as a good hedge against non-consensus outcomes such as a US recession or a sudden stock market meltdown. But we don't see much upside from owning bonds in the UK, Germany and Japan as 10 year yields remain very low or negative.

Q: How are you currently positioned in the high yield space?

A: Currently, our strategy owns around 7% HY corporate bonds, well diversified geographically among the US, Europe and Asia. We have an emphasis on high conviction names favored by our internal credit PMs and analysts.


Q: How important are emerging markets, and China in particular, in a global portfolio?

A: As mentioned earlier we have been very vocal that the "New Global" is the G20 rather than the narrowly focused G7. G20 countries account for more than 80% of global GDP, trade, and financial asset capitalization, while G7 accounts for less than 45% of global GDP. China is already the third largest bond market in the world but it had zero representation in the bellwether Global Aggregate Bond Index before Bloomberg decided to include China in April 2019. China's weight in this widely followed global bond index will rise to near 6% by the end of 2020. We believe that broadening bond investment from G7 to G20 countries will allow investors to achieve higher potential returns and better diversify portfolio risks.

Q: What can investors expect from the inclusion of Chinese bonds in global bond indices?

A: Once China's weight in global bond indices rises to around 6% and because of its lower correlation with other bond markets, investors, especially in global bonds, should be able to enhance portfolio returns. However, investors must be familiar with China's economy and financial market structures; as we often say, "do your homework". UBS AM has been very early and proactive in entering China's equity and bond markets with the best presence among foreign banks and asset managers. It is important for investors to understand that China is not a typical EM market nor investors should apply their experience and skills learnt from developed markets blindly to investment in China given drastically different political, economic and financial systems.

Q: Which currencies do you like the most and why?

A: In developed countries we like Norwegian and Swedish Krona versus EUR because of their attractive valuation, positive carry and superior economic growth. In addition, we like a few relative value positions such as long AUD vs. NZD. For EMFX, we are selectively long those currencies that offer attractive carry in an environment of moderate global growth and low G10 rates. For instance we are short both USD and CAD versus long in CNY, BRL and CLP. In addition, we also hold a few diversified relative value positions within EMFX such as long TRY vs. RUB, Long MYR and KRW versus TWD and THB.

Q: The carry has always been an important contributor to fixed income strategies. Do you think that it is still the case?

A: It is true that spreads in many cases are currently at historically low levels, implying less than average future returns from carry. However, given moderate global growth, supportive central bank monetary policies and relatively low risk of an imminent global recession, carry still has a role to play in bond portfolios; for example, positive carry on the yield curve or across credit default swaps of similarly rated sovereigns.

Global Dynamic Bond strategy


Q: The strategy has a very flexible investment approach. Can you name a recent market situation when flexibility paid off?

  1. In September 2017 we went significantly short duration in the US in anticipation of the Fed hiking cycle as a result of synchronized global growth and Trump tax cuts.
  2. From late 2019 we went very short Eurozone duration as German bonds traded at very negative yields and markets were over confident of the ECB delivering large rate cuts and large asset purchases. In our view, the ECB deposit rate of -0.5% was already nearly at the ELB (effective lower bound) and the ECB had very little room to buy bonds in countries with limited supply such as Germany.
  3. Long diversified EM bonds in China, Mexico, Brazil and Russia for most of time in 2019 on significantly higher yields and prospects for deep rate cuts by the respective central banks.
  4. Long inflation linked bonds in the US and New Zealand when real yields were too high, when market implied inflation was significantly below the central bank inflation target and what has been achieved historically.

All the above demonstrate the benefits of a flexible investment approach in terms of duration, deviation from a market based bond index or investments in countries or assets not well represented in global bond indices. Some of the relative value strategies require flexible use of interest rate futures and swaps on the short leg of the trade or for hedging portfolio risks.

Q: How is the portfolio positioned for the current market environment?

  • Portfolio duration around 5.7 years mid-point of guidelines range 0-10 years
  • Focus on cross country relative value opportunities. We are long fixed income in US, China, Mexico, New Zealand, India, South Africa and Canada vs short in Switzerland, Japan, Germany, UK and Hungary/Poland
  • Below average allocation to corporate bonds balanced with above average allocation to emerging market bonds and securitized bonds
  • FX: long NOK and SEK versus EUR, long AUD vs. NZD, short both USD and CAD versus long CNY, BRL and CLP. In addition, we also hold a few diversified relative value positions within the EMFX such as long TRY vs. RUB, Long MYR and KRW versus TWD and THB.

Q: Which do you expect to be the most important performance drivers for the Global Dynamic Bond strategy in the coming months?

A: We always strive to deliver diversified returns from multi assets, countries and style of investment strategies within the fixed income universe through risk budgeting and combining both long-term allocation with shorter term tactical strategies. For 2020, we expect very limited returns from a decline in developed bond market yields or spread compression. Instead we emphasize relative value across countries and yield curves, and focus on those EM countries that have significant room for monetary easing; due to either weak growth and/or falling inflationary pressure.

Want to know more about flexible fixed income investing?

Read more about how flexible fixed income investing can help you navigate potentially volatile fixed income markets yet take advantage of opportunities as they arise


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