Charlotte Baenninger, head of fixed income at UBS Asset Management, said investors should be optimistic due to the stability of yield as a component of total returns for bonds over the long term, the higher break-evens that higher yields provide, and the lower risk now that investors don’t have to reach for yield.
“Over the past 20 years, yield (income) has been the dominant driver of total returns in bond portfolios. For certain asset classes, such as high yield and emerging markets, price return has been negative over the long term yet performance has been positive and very strong, demonstrating the power of yield,” Ms Baenninger said.
“Despite the large role yield plays in total return, it only contributes a minor proportion towards total return volatility.”
In terms of break-evens, Ms Baenninger said that due to the head-start provided by yield income from a total return perspective, the magnitude of rate increases needed to wipe it out is increased.
“In general, the higher the level of yield, the larger the magnitude of rate increases required to generate a negative total return (i.e. wipe out positive contribution from income),” she said.
“Looking at the Bloomberg Global Aggregate Index, break-evens were at 17 bps (basis points) at the beginning of the year; they are now at 57 bps. The Global Aggregate Corporates Index has risen from needing 25 bps of yields rising to 92 bps before negative total returns set in.
“The short-duration sectors are really shining; this is because curves have flattened, and short-duration assets have much less interest rate sensitivity. At the end of 2021, the Global Aggregate 1–3 Year Index required just a 38 bps rise in bond yields to generate a negative return. More recently, this same benchmark now requires nearly 190 bps of yield increases to erase its higher yield advantage.”
Ms Baenninger added that in an environment of ultra-low government bond yields and steep yield curves, investors would need to either take on more interest rate risk by going further out on the maturity curve or take on more credit risk by moving down the credit quality spectrum.
“Investors now have much greater flexibility to achieve their yield targets, but clearly, while there are benefits to having higher yields today, we should keep in mind that, with the Federal Reserve and other central banks focused on stamping out persistently high inflation, markets are likely to remain volatile over the short-to-medium term,” she said.
“However, for long-term investors, bonds are arguably better placed today to handle any further price declines than in the past.”
