Fixed income in a healing world

2014 looks like it will be different to 2013 in two important ways. One is the starting point, with yields in Australia and the US around 1% higher than a year ago. This will ensure that investors lock in more attractive prospective returns. This must be set against the other important difference between the two years: the developed world seems to be on much firmer footing than it has been for some time. This will likely be reflected in a further rise in yields globally which will weigh on short-term returns.

Global

While emerging markets have been fragile of late, the developed world continues to heal. Indeed, the developed world has started 2014 with no obvious events risks that could disrupt growth. This is the first time in many years that this is the case. The US economy seems to be growing strongly. The private sector is in good shape and the government is not tightening fiscal policy this year. This should see the unemployment rate fall to the Fed's 6.5% threshold at which it will review its interest rate settings. The UK is in a similar position, with the unemployment rate falling quickly towards the Bank of England's 7% threshold for considering rate rises.

Neither central bank will raise rates when those thresholds are hit but discussion around this issue will be a key focus for markets. An increase in the Fed funds rate is very unlikely in 2014 but the Fed will continue to slowly reduce its asset purchase program. Europe seems to be in a very different position. Growth is recovering slowly but inflation has fallen sharply. Deflation is a risk in Europe, but not the central case. The ECB will continue to keep policy very easy in response. While markets remain concerned about some aspects of China's financial system, growth has settled into a more moderate 7-8% range. This is desirable from a longer-term perspective and helps reduce the risk of major imbalances derailing the outlook.

Australia

On the surface, we appear to be in for more of the same in Australia: slow growth and low inflation. Below the surface, the story is more nuanced. The transition from mining investment led growth to growth driven by stronger domestic demand and exports is underway. It is still an open question whether this transition will be smooth but the prospects for such an outcome are brighter than they have been for some time. Against this backdrop, the RBA seems content to leave the cash rate at 2.5% for some time. Given the moderate growth outlook we struggle to see the RBA tightening in 2014. However, if the economy improves the market will price that kind of outcome.

Market Implications

Putting this together suggests that yields will rise moderately through 2014, with the US and UK markets the most vulnerable to higher yields. Australia will be caught up in that adjustment, although yields should not rise as much given our softer growth prospects. The rise in global yields should see Australian 10-year bond yields rise to 4.5%, around 40 basis points above current levels. In addition to yields rising, we expect that yield curves will flatten from their very steep levels. Yield curves are historically very steep in most markets, on the assumption that central banks will pin short-term rates. The current steepness of curves implies that the market already discounts higher long-term yields in the future: in technical terms, forward starting yields have increased to more normal levels. This suggests to us that it is difficult for curves to keep steepening even in the face of stronger growth.

An environment of improving growth, moderate inflation and a slow withdrawal of stimulus by some central banks should underpin steady excess returns from corporate securities. With spreads narrower than they have been for some time, this is likely to be driven by ongoing carry rather than relative capital appreciation. Volatility is likely to be higher as we are further into the credit cycle and current pricing leaves less margin for error than the past few years.

Australian Bond Fund

These views are reflected in the UBS Australian Bond Fund in a number of ways. We have reduced the interest sensitivity of the portfolio to below benchmark. In addition, we have biased the portfolio towards longer-dated securities. Longer-dated yields have increased to more normal levels so they should be more insulated from better economic news and rising global yields than short-term yields. We believe corporate and semi-government bonds continue to offer good value even though their spreads over Commonwealth bonds are narrower than they have been for some time. So we continue to bias the portfolio towards these sectors.

Diversified Fixed Income Fund

We began to position the UBS Diversified Fixed Income Fund around the middle of 2013 to reflect a number of the themes expressed above. Specifically, we shortened duration, eliminating all interest rate exposure to the US and UK markets; we biased the portfolio to longer-dated assets; we increased our exposure to Europe and remained overweight Australian interest rate risk, although in smaller size than early in the year. These changes reflected a desire to cushion the portfolio against rising bond yields by being short duration and overweight markets or parts of the yield curve that were better insulated from upside surprises to global growth. In terms of asset allocation, we are still overweight Australian fixed income assets, at around 60% of the Fund. We remain overweight credit, largely through our exposures to US high yield and credit overweights in the underlying funds.

Conclusion

With yields higher than a year ago, fixed income investors start 2014 in a more favourable position. As we have noted elsewhere , medium-term returns will best reflect the underlying yield at the time of investment. As at 31 December 2013, the UBS Australian Bond Fund yields 4.03% while the UBS Diversified Fixed Income Fund yields 4.48%. Over the medium-term, investors should expect these portfolios to generate returns of this order of magnitude. From a shorter-term perspective, we are still in an environment of rising yields. While we are probably more than half through this adjustment in Australia, a further rise in yields will restrain fixed income returns in the near term.

About Warren Tease

Warren Tease is Head of Interest Rates at UBS Australia and is also a member of the Global Fixed Income Investment Committee. He has 27 years of experience in the investment industry.

At UBS, Warren has responsibility for the development of Australian and global interest rate strategies across Australian composite and diversified fixed income portfolios.

He joined UBS in January 2005 after three years’ experience with Morgan Stanley. He has also previously worked at Schroders Australia and had 11 years’ experience with the Reserve Bank of Australia.