Interest rates and bond markets

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1 CIO WM Research 22 October 213 Interest rates and bond markets Outlook & Strategy: Taper postponed again Major government bond yields have backtracked from their multi-year highs and have been zigzagging in tight ranges since mid-september. The negative ripple effects of the government shutdown will likely result in a later taper and slightly lower yields over the next one to four weeks, but do not change our forecast of a secular uptrend in rates. The normalization of historically low interest rates over a longer horizon remains our base case. Within our underweight of sovereign bonds, we advise investors to be selective regarding sovereign bond issuers and possibly consider government bond alternatives, as well as, depending on their risk/return profiles, lower-rated bonds from the corporate sector. As expected and captured in our August forecasts, global yields have backtracked from their summer highs, trading in tight ranges since mid-september. Data uncertainties after the prolonged US government shutdown and the prospect of renewed fiscal uncertainties in the US resulted in lower global short and longer yields. The front end of the curve fell in anticipation of a delay to Fed tapering and a substantial dovish shift in rate hike expectations. The long end of the US curve followed as the US economy lost momentum. UK, Bund and Swiss yields followed the US move due to the high correlation to US yields. We share the view that the Fed is likely to postpone the reduction in asset purchases from December 213 to March 214 on the basis of temporarily weaker data and the likelihood of a renewed budget fight in Q Daniela Steinbrink Mattei, strategist, UBS AG Teresa Sardena, analyst, UBS AG Nina Gotthelf, analyst, UBS AG With contributions from our UBS AG analyst Bill O'Neill and Jonas David, our CIO strategists Bernhard Obenhuber, Achim Peijan and Philipp Schoettler and UBS FS analysts Thomas Berner and James Rhodes This report was originally published outside the US and has been customized for US distribution. Fig 1: Interest Rate Forecasts Europe mths 6 mths 12 mths End 13 EUR 3M Libor EUR 2Y Bund EUR 5Y Bund EUR 1Y Bund CHF 3M Libor CHF 2Y Eidg CHF 5Y Eidg CHF 1Y Eidg GBP 3M Libor GBP 2Y Gilt GBP 5Y Gilt GBP 1Y Gilt Americas mths 6 mths 12 mths End 13 USD 3M Libor USD 2Y Treas USD 5Y Treas USD 1Y Treas Asia mths 6 mths 12 mths End 13 JPY 3M Libor JPY 2Y JGB JPY 5Y JGB JPY 1Y JGB Source: Reuters, UBS Temporary lower economic momentum is likely to result in lower US yields over the next one to four weeks. However, we believe the loss in economic momentum will only be temporary, with momentum picking up again. Yields should therefore resume their uptrend over three to six months. Over six months, we expect a reacceleration in global growth as well as a stronger US private sector and robust employment growth in the US. This should allow the Federal Reserve to begin tapering by gradually reducing its asset purchases and ending quantitative easing by late 214. Global benchmark yields should receive another upward push over the next 6 to 12 months and continue their long-term normalization process. This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 7.

2 USD: Rates uptrend not slowed by US government shutdown The forecast of a secular uptrend in Treasury rates has not been affected in any significant way by the government shutdown or the resolution of the budget fight being delayed to 214. The loss of economic momentum due to the shutdown is likely to be temporary, as most of the spending lost during the shutdown will be recouped. While we haven t changed our Q4 213 real GDP growth forecast of 2.7% annualized, we are expecting high-frequency economic reports to show a dent in growth for October followed by a rebound in November or December. Murkier data and less growth momentum coupled with the possibility of another budget fight in Q1 214 suggest that the Fed will delay its taper. We now expect an initial taper in March 214, rather than this December. While we suspect that Congress will again reach a last-minute budget deal possibly as late as early March, when the Treasury has exhausted all bookkeeping measures and is unable to operate beneath the debt ceiling again, we don t expect the shutdown to repeat itself. The recent traumatic experience should serve as a deterrent and negotiations should be less fierce. The government is thus nearly as likely to strike an early deal in January before the current resolution to fund the government expires on 15 January as it is to fight until the last minute. Fig. 2: The recent developments do not alter our six month forecasts US Treasury 6-month forecasts and US treasury forward curve Mo 6Mo 1Yr 2Yr 3Yr 5Yr 7Yr 1Yr 3Yr Actual US Treasury yield curve 1 Yr Forward US Treasury yield curve 2Yr Forward US Treasury yield curve 3Yr Forward US Treasury yield curve 6 months CIO Forecasts Social Security Administration, Bloomberg, UBS Despite the recent developments, temporary loss in economic momentum and change to our view on a Fed taper, our six-month forecasts are not being altered. We expect that by late April, economic conditions will be similar to before the shutdown: stronger global growth, accelerating US private sector demand and employment growth, fading US fiscal drag, subsiding US fiscal policy uncertainty, an uptrend in US inflation and somewhat higher US inflation expectations. We therefore maintain our forecast of the 1-year Treasury yield rising to 3.% in six months. As we expect economic conditions in 12 months to be similar to those prevailing in six months but with a more mature taper and greater proximity to a first rate hike predicted for 215, we also keep our higher 12-month forecast of 3.3%. Over the coming weeks, Treasury rates may fall lower yet as the market assesses what is likely to be disappointing growth data and the risk of a material growth slump in the aftermath of the shutdown. However, we expect the 1-year Treasury yield to climb to 2.8% in three months, as growth reaccelerates and the Fed moves closer to an initial taper. Thomas Berner, UBS FS UBS CIO WM Research 22 October 213 2

3 EUR: Data remains supportive of ongoing normalization as ECB sidesteps In recent weeks, 1-year Bund rates remained rooted at 1.8%: the political uncertainty coming from the US fiscal debate and the European Central Bank's (ECB) reiteration that potential remains for further action to ease money market conditions counterbalanced the upward push coming from the normalization underway in the European economy. The recent Eurozone data flow confirmed that the region is slowly strengthening. September purchasing managers' indices reached a mark not seen in more than two years (July 211), driven by stronger forward looking and employment components and industrial production data bounced back in August, after a revised 1% drop in July. Given this brighter economic picture, the ECB left key interest rates unchanged and took no further non-standard measures at its October meeting. The ECB did maintain its dovish bias, since the risks remain skewed to the downside, while the picture for inflation was seen as balanced. Nevertheless, during the Q&A session President Mario Draghi underscored that the ECB remains "ready to consider all available instruments to avoid a liquidity shortage and to aid money markets. According to the CIO, the most likely instrument would be an extension of the full allotment liquidity facility beyond July 214, which should ensure that liquidity is available to solvent banks against adequate collateral. Thus, over a six-month horizon, we expect Bund yields to trend slightly higher, as we believe interest rates still have to catch up with better fundamentals given an improvement in Eurozone growth prospects and ongoing reduction in the safe haven premium. Within 12 months we anticipate that yields will be trading at 2.6%. We also forecast the Bund yield curve to steepen further: in our view, the short end of the curve will remain anchored as the ECB eventually succeeds in decoupling the front end of the curve from short-term US yields. In contrast, the long end of the curve will be driven by the strengthening Eurozone business cycle and the close correlation to US yields. CHF: in wait and see mode The Eidgenossen yield curve has remained largely unchanged in recent weeks, reflecting the deadlock in the US fiscal standoff. Swiss interest rates meanwhile were unmoved by constructive domestic economic data, including a strong 2Q GDP, PMI Manufacturing and KOF leading indicator reading. We still do not see a significant directional trigger, and expect Swiss yields to move sideways to slightly higher over a three-month horizon. Over a six to 12-month horizon as economic growth begins to accelerate in Europe, interest rates should normalize and thus trend steadily higher. Fig. 3: Better economic momentum remains a key driver for Bund Yields Eurozone composite PMI and 1y Bund yields (%) Sep-5 Mar-6 Sep-6 Mar-7 Sep-7 Mar-8 Sep-8 Mar-9 1-yr Bund yields (LHS) Sep-9 Mar-1 Sep-1 Mar-11 Sep-11 Mar-12 Sep-12 Eurozone Composite PMI Fig. 4: Improving PMI profile has been helped by lower policy uncertainty in the Eurozone Eurozone composite PMI and Eurozone policy uncertainty Sep-5 Mar-6 Sep-6 Mar-7 Sep-7 Mar-8 Sep-8 Mar-9 Sep-9 Mar-1 Sep-1 Mar-11 Sep-11 Mar-12 Eurozone Composite PMI EurozonePolicy Uncertainty (RHS reverse order) Fig. 5: Swiss yields stabilize at higher levels EURCHF exchange rate vs. 1-year Swiss yield in % 3.5 % 3. % 2.5 % 2. % 1.5 % 1. %.5 %. % Oct-9 Apr-1 Oct-1 Apr-11 Oct-11 Apr-12 Sep floor Oct-12 Apr-13 Mar-13 Mar-13 Sep-13 Sep-13 Oct SNB intervenes with 47bn CHF SNB intervenes with 17bn CHF 1Y Eidgenossen Yield SNB intervenes with 144bn CHF SNB intervenes with 16bn CHF EURCHF Source: Bloomberg, UBS UBS CIO WM Research 22 October 213 3

4 UK: Bright spot Gilt yields fell since mid September, reflecting the general unease surrounding the US fiscal standoff as well as peaking domestic economic indicators. Nevertheless, longer dated UK rates remain firmly anchored above their US counterparts, reflecting the Bank of England stance of not protesting current yield levels. In light of stronger domestic growth and sticky inflation ahead, interest rates are set to move slightly higher over a six-month horizon as the yield curve steepens. Fig. 6: UK yields fell slightly UK base rate vs. 1-year Gilt yield in % 8% 6% 4% 2% % EM: breathe easier as Fed stays hand Emerging market (EM) bonds denominated in USD have performed well since the Fed's decision to delay the start of tapering its asset purchase program. EM sovereign bonds returned 2.1% over the last month as spreads declined by 13bps and reference rates dropped by 8bps. EM corporate bond (+2.2%) performance was in line with sovereign bonds and spreads declined by 18 bps. Overall EM bonds recouped their August losses. Oct-6 Oct-7 Oct-8 Oct-9 QE1 UK base rate Extension Announcements Source: Bloomberg, UBS Oct-1 Oct-11 QE2 1-year Gilt yield Oct-12 Oct-13 At the same time, the average yield of local-currency EM government bonds slid towards 6.34% from 6.64%. The total return of 3.9% in USD terms over the last month, however, was also supported by a relief rally of EM currencies when the Fed decided to postpone the reduction of asset purchases. To put things into perspective: since the beginning of the year, the benchmark index for local-currency bonds is still down by more than 4%, driven entirely by the fall in EM currencies. Fig. 7: EM corporate rating trend remains negative Trailing 3m net rating migration rate, in % of issuers 1 5 Recent economic data out of EM has been mixed. Leading indicators such as PMIs improved for most major EM economies. Mexico and South Africa were notable exceptions. However, the broader country risk measure continued to weaken some. In addition, the latest corporate data suggests that credit fundamentals worsened in 2Q as earnings growth stayed weak and re-leveraging continued. Although major EM credit indices recognized no bond default in September, the overall rating migration is still negative (see Figure 7). Another sign of improving sentiment came from the primary market, revived after the summer months. EM sovereigns and corporations issued USD 19.7bn and USD 32.5bn in new bonds in September. This compares to just USD 1.5bn of new government and USD 5.3bn of new corporate bonds in August. However, the demand side for EM bonds is still rather weak; mutual funds have experienced outflows in 18 of the last 19 weeks. Only late September inflows exceeded outflows by a small margin before slipping back into negative territory. (5) (1) (15) (2) Source: BAML, UBS EM IG EM HY Overall, we find that sentiment and economic data have improved slightly compared to the previous month. However, we find that general conditions for EM bonds suggest a neutral stance on the asset class. We maintain a neutral allocation to EM sovereigns and corporates and prefer developed market credits in our global credit strategy. Jonas David and Bernhard Obenhuber, UBS UBS CIO WM Research 22 October 213 4

5 Corporate bonds delivering solid returns Investment grade (IG) corporate bonds, denominated either in USD or in EUR, have weathered the recent turmoil around the US fiscal debate well. While spreads have been by and large stable over the last month, total returns were helped by the fall in benchmark rates. As a consequence, global IG corporate bonds delivered a return of 1.5% over the month, outperforming government bonds. We expect outperformance to continue and thus keep our preference for IG corporate bonds. In the US high yield (HY) segment, spreads widened mildly after the US Fed's decision not to taper quantitative easing (QE) in September. But this move reversed recently, also helped by the temporary solution to the US budget and debt ceiling fight. The fall in Treasury benchmark rates additionally helped total returns which stand at 1.7% over the last month. The current yield (to maturity) of 6.5% remains attractive given very low default rates and our constructive outlook on company earnings and credit quality. Over a six-month horizon the backdrop of supportive economic growth and monetary policy are likely to dominate the remaining risks and lead to tighter spreads again. Philipp Schoettler, UBS US agency debt market: Washington s follies breathe new life into the carry trade The soap opera that the negotiations about government funding and the debt ceiling has turned into is growing very old very fast. Due to the unfinished nature of the recent agreement, the specter of political acrimony is unfortunately likely to continue to loom over the market for the remainder of the year. While such potential volatility would normally suggest an underweight for products that are inherently short volatility (e.g. agency callable bonds, mortgage-backed securities), we don't believe this is the case now, as the Fed will likely be forced to delay its plan to taper its large-scale asset purchases (as noted previously, we now expect a taper in March). Continuing central bank accommodation in the form of QE augurs well for the carry trade, a strategy involving owning a bond to profit from clipping the coupon and rolling down the yield curve as it matures, and should continue to support the agency and mortgage markets. Fiscal policy uncertainty should also remain fairly dormant, at least until the next deadline on 13 December, when lawmakers are supposed to agree on budget principles. Regarding the carry trade, we note that the peak of the expected carry and roll-down curve for large liquid agency bullets (i.e. non-callable bonds) is near the six-year point on the yield curve, both on an absolute and an incremental basis (i.e. versus the rest of the agency bullet curve and matched maturity Treasury notes, respectively). The trough, where agency bullets are least attractive versus Treasuries, is at the four-year point on the curve; here, Treasuries are not only the more liquid alternative, but are also expected to outperform agencies on a total return basis, assuming the six-month forward curve is realized. James Rhodes, UBS FS Fig. 8: High yield bonds trump other fixed income assets again Various fixed income assets Jan-13 Feb-13 Mar-13 Apr-13 Investment grade Loans EM corporate bonds Source: Bloomberg, UBS May-13 Jun-13 Jul-13 Aug-13 Sep-13 High yield Treasuries EM sovereign bonds Fig. 9: Agency carry peaks around the six year Carry & roll down (bps) (1) (2) Oct Maturity (yrs) Treasury Agency Agency - Treasury CIO, Bloomberg, Yield Book Note: Assuming six month holding period with no financing, as of 21 October 213 UBS CIO WM Research 22 October 213 5

6 Our view on duration We have a preference for government / high grade bonds with medium maturities, i.e. bonds with maturities between three and seven years. Investors who manage their fixed income portfolio versus a benchmark should keep the duration of the portfolio close to benchmark duration (which for a private client should typically be around five years). From our point of view, medium-term bonds provide the best risk/ return characteristics based on our longer term interest rate forecast, but also if we look at the carry (i.e. essentially the coupon for a bonds that notes at par) and roll down that we can expect for the various maturities segments relative to the risk incurred. Given the steep yield curves in the USD, EUR, GBP and CHF bond markets, the coupon rises with the maturity of the bond; in the case of the US market, for example, from.1% to 1.3% for the next 6 months (for maturities between one and 1 years; see Fig. 1). In addition to the coupon, the current yield curves provide significant roll down returns. For example, if we assume that yields remain unchanged over the next 6 months, an investment into a five-year US Treasury bond will gain roughly.7% from roll down (i.e. the fact that the five-year bond is only a 4.5-year bond in 6 months priced at lower yields), in addition to a.7% contribution from carry / coupon. When combining carry and roll down, we find that the overall expected returns are rising with maturities, but only slightly. Therefore, when taking into account that risks also rise with maturity, medium-term bonds currently provide the best risk/return characteristics (i.e. provide most return for the risk taken) from our point of view (see Fig. 11). If we take our interest rate forecasts in USD and GBP, we can reach a similar conclusion. Expected yields are slightly higher at the long end, but not such that the additional risk is well compensated. In the case of EUR and CHF the expected returns are lower, in general, and more evenly spread across maturities. Taking into consideration the higher risk of longer term investments, we favor bonds with medium maturities. Achim Peijan, UBS Fig. 1: Significant performance contribution from roll down Return drivers for USD bonds over next 6 months 1.4% 1.2% 1.%.8%.6%.4%.2%.% Carry Roll down Maturity (years) Fig. 11: Attractive risk return in medium-term bonds Expected return, risk and information ratio for USD bonds 9% 8% 7% 6% 5% 4% 3% 2% 1% % Maturity (years) Expected return (lhs) Vola (lhs) Return / Risk (RHS) 35% 3% 25% 2% 15% 1% 5% % UBS CIO WM Research 22 October 213 6

7 Appendix Global Disclaimer Chief Investment Office (CIO) Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/ or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are currently only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment decisions (including whether to buy or hold securities) made by UBS AG, its subsidiaries and employees thereof, may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law. Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-us affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-us affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. Version as per September 213. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. UBS CIO WM Research 22 October 213 7