UBS sees better bond carry in 3-5 year debt after global selloff

Investing.com -- The global bond selloff has opened up more attractive avenues for earning income from credit, yet UBS advises against piling into the highest-yielding long-dated bonds, where rising volatility in interest rates and worries about heavy debt supply make the risk-reward less compelling.

UBS states it has adopted a tactically more cautious stance on duration following a sharp jump in interest-rate volatility and an aggressive bear flattening of global yield curves during the second half of August. However, the bank is not turning outright negative on credit because spreads have stayed relatively resilient, leaving scope to harvest carry on a more selective basis.

"Carry" essentially denotes the income investors earn from holding a bond, including the coupon and any gain or loss from shifts in the yield curve. UBS contends that the most promising opportunities now reside in market segments where that income is relatively generous compared with the volatility investors are exposed to.

Why UBS is moving away from the long end

The most prominent red flag is that the bond selloff has not yet triggered a broad widening in credit spreads, but volatility in spreads is climbing noticeably in long-dated investment-grade and some high-yield bonds.

UBS says this signals investors are growing more uneasy about holding longer maturities while interest-rate volatility remains high.

The bank sees a critical threshold ahead: a U.S. 10-year Treasury yield near 5%. Should it rise further beyond that mark, particularly if markets begin pricing a genuine Fed hiking campaign rather than a brief “insurance-style” cut, credit markets may find it increasingly hard to stay insulated from the rates selloff.

UBS also highlights AI-driven bond issuance as another cause for caution at the long end. Large-scale technology and infrastructure spending plans are boosting debt supply, while investors are demanding greater compensation for taking on duration risk.

UBS' preferred carry trades

The bank's favored positioning is distinctly defensive. It recommends taking profits in U.S. high-yield bonds and shifting up in quality, while favoring three- to five-year investment-grade bonds globally. It also prefers cash over synthetic credit exposure and likes European credit better than U.S. credit.

UBS' model finds the European front end particularly appealing, especially after the recent repricing of monetary policy. U.S. investment-grade bonds with three- to five-year maturities also fare well in the model because their spread volatility is lower and their correlation with equities has declined.

For investors holding cash alongside credit exposure, UBS' model prescribes a substantial cut in U.S. high-yield allocations within the three- to five-year sector and a larger shift toward global investment-grade debt in the same maturity bucket.

Its derivatives-only model is more tactical: reduce exposure to iTraxx Main, take profits on iTraxx Xover, redirect funds into CDX High Yield, and maintain a short position in emerging-market credit.

Another risk UBS points to is positioning. CTA exposure to credit is already stretched, and the bank warns that a spike in volatility driven by negative headlines could force systematic investors to slash long positions or even flip to short, particularly after a two-standard-deviation move.