attractive yields after the end of the low-interest phase

The low-interest phase is over, the US central bank and the European Central Bank (ECB) are raising interest rates every month, as they did last Wednesday, in order to combat inflation. The Swiss National Bank (SNB) is also tightening interest rates. In view of the rising interest rates, the question arises as to whether investors should now increasingly switch to bonds.

So far, 2022 has brought significant losses to bond investors, which is also related to rising interest rates. With bonds, yields rise when prices fall. According to VP Bank, mixed bond indices consisting of government and corporate bonds of solid quality have suffered historically high losses this year. In Switzerland it was -11.9 percent at the end of October, in the euro zone -16.1 and in the USA -15.7 percent.

At the same time, bonds are now being issued with higher interest rates. This tends to make fixed income more attractive. In addition, after a long period of time, bond yields are again approaching or even exceeding most dividend yields. In the event of a recession, dividend payments can also be reduced or not paid at all. If investors then increasingly switch from stocks to bonds, capital flows from stocks into bonds. This is likely to have a negative impact on share prices.

In the long term, however, the facts speak for themselves. According to the long-term study by Bank Pictet, 100 francs invested in shares in 1926 increased to 20,592 francs in real terms in 2021 – i.e. after deducting inflation. CHF 100 invested in bonds during the same period was worth only CHF 821 in real terms in 2021.

What speaks for bonds

Despite this huge difference, there are reasons to invest at least part of your wealth in bonds. One reason is diversification. Stocks and bonds tend to be negatively correlated, which means they usually move in opposite directions. So when stocks go up, bonds go down and vice versa. However, this interaction did not play a part in the recent correction on the financial markets. Both share prices and bond prices fell.

Another reason to hold bonds is often justified by safety. While stocks could fall sharply in value overnight if a company encountered unexpected difficulties – which of course can also be the case the other way around if unexpected success occurs – bond holders slept well, it is said.

However, this is only partially true when you think of the Swissair bankruptcy. According to the lawyer and member of the liquidation team Filippo Beck from the law firm Wenger Plattner, anyone who owned bonds issued by SAirGroup still received 23 percent of the invested capital. With obligations issued by SAirGroup Finance US Ltd. were published, you got back 100 percent of the capital.

Anyone who buys bonds can earn income from the interest rate or from the price of the bond. You have to keep in mind that rising interest rates lead to a fall in the price and, conversely, falling interest rates lead to a rise in the price.

For example, if you buy a bond for 1,000 francs with an interest rate of 2 percent, you will receive 20 francs at the end of the year. If the interest rate rises as a result, the bond purchased loses value, since a newly issued bond would yield an interest rate of 2.5 percent, for example. Consequently, the price of the bond held falls to around 800 francs for a perpetual bond, because the 20 francs that one still receives annually corresponds to 2.5 percent of 800 francs. In the case of a bond with a remaining term of 10 years, the price would fall from 1000 to around 950 if the market interest rate increased by 0.5 percent, since the impact on the market price is also a function of the fixed interest rate (in this case a duration of around 10 years).

If an investor holds the bond until the end of the term, he will still get back the CHF 1,000 originally invested. But its interest income will be lower than the market interest rate during the term. However, those who hold shares do not always hold the shares with the best price performance.

Hold until expiration is often recommended

“If the quality of the bond allows it, we recommend holding the bond until maturity,” says Claudio Paonessa, senior portfolio manager at Basler Kantonalbank (BKB). If sold, the loss would be realized. If you hold the bond until maturity, you get back the invested capital.

Since a certain interest rate is usually fixed for a bond for several years, as an investor you have to think carefully about when you want to invest in a bond.

If interest rates are expected to rise in the near future, it might be worth holding off on buying bonds in order to achieve an optimal return with the highest possible interest rate. If it looks like interest rate cuts, you should rather invest in bonds quickly.

We are currently in the middle of a cycle of rising interest rates. In view of the high inflation, the central banks are pursuing a more restrictive monetary policy, which means they periodically raise interest rates in order to lower the cost of money. Over time, this should reduce demand for money, goods and services, thereby reducing inflation.

As an investor looking to invest in bonds, the question arises as to when this cycle will reach its upper inflection point so that you get an optimal interest rate. In addition to the general level of interest rates, the creditworthiness of the debtor also determines the interest rate offered. Federal bonds are considered absolutely safe, which is why the interest rate is lower than that of other borrowers.

Established companies, on the other hand, pay a higher interest rate than state institutions, but less than “junk bonds”. These are high-yield risk bonds from companies whose future prospects and financial situation are difficult. For the high risk that investors take with their loan, they are compensated with a high interest rate. However, they run the risk that such a company could become insolvent.

Paonessa from BKB now sees the interest rate level in certain sub-markets at a very attractive level in absolute terms when you compare the interest rates with the dividend yields of shares. For Olivier Hildbrand, Head of Franconia Bonds at Pictet Asset Management, the time is right to buy bonds. He agrees with the SNB’s expectations that inflation in Switzerland will have peaked by early 2023 at the latest. This should also stabilize interest rates.

The rapid increase in inflation surprised the markets, which is why interest rates on bonds rose relatively quickly and sharply. “With short-term bonds, there is a risk that interest rates will rise due to the risk of inflation, but with long-term bonds, interest rates already offer interesting entry points due to fears of recession,” he says.

Pictet currently rates federal bonds as unattractive. Ten-year Confederates, for example, yield a return of 1.11 percent, while mortgage bonds for the same term and with almost the same credit rating bring a return of 2 percent. Other attractive debtors are the cantons or those that can count on a guarantee from the public sector, such as the BLS railways.

Bonds from banks, insurance companies and utilities

When it comes to corporate bonds, Hildbrand is interested in subordinated bonds from banks with strong balance sheets such as UBS and Zürcher Kantonalbank, as well as insurance companies such as Swiss Life, Bâloise and Helvetia or utilities such as Axpo. In the case of subordinated bonds, in the event of the liquidation or bankruptcy of the issuer, creditors must subordinate claims to non-subordinated debt. To compensate for the higher risk, sustainable bonds pay higher interest rates than ordinary bonds. However, the risk of bankruptcy is manageable for the companies mentioned.

With a view to the term of the bonds, the Pictet expert recommends a maximum of ten to fifteen years, because the yield curve is then inverted. This means that bonds with longer maturities are offered at lower interest rates, even though you tie up your money for a longer period of time.

BKB recommends dollar and Swiss franc bonds. Dollar bonds should only be bought without currency hedging, as the hedging costs are currently too high due to the high interest rate differential for short maturities. The difference in interest rates between corporate and government bonds is currently quite attractive due to the higher credit risk, so that BKB also recommends corporate bonds.

“We would not currently recommend high-yield bonds, as they are heavily dependent on the mood on the stock markets and could therefore be affected more quickly by poor market sentiment,” says Paonessa. On the other hand, he has been recommending emerging market bonds since the middle of the year after the BKB temporarily withdrew this recommendation due to the outbreak of the Ukraine war.