Where we stand: a tale of two (or multiple) speeds

The memory of 2022’s brutal repricing in bond markets still lingers among investors. They recall how central banks worldwide combated the inflation surge by hiking policy rates into restrictive territory, causing rates and yields to spike globally. 

However, this significant shift also produced a silver lining: the price reset ultimately allowed investors to reinvest at nominally better levels, including more cushioning. 

Since then, the global bond market has become increasingly complex, with diverging dynamics that are particularly challenging for Swiss investors. In the US, for instance, the Federal Reserve has adopted a cautious stance following its initial rate cuts in late 2024. What’s more, longer-dated bond yields remain elevated due to concerns over erratic policy out of Washington, ongoing inflation risks, consistently high fiscal deficits, and a general desire to diversify away from US dollar assets. 

By contrast, Switzerland’s situation is very different. The country’s low inflation and strong currency have pressured the Swiss National Bank (SNB) to return quickly to low policy interest rates. Indeed, at the time of writing, the SNB lowered its policy rate to 0%, and further decreases into negative territory are possible. Naturally, investors are left wondering how to effectively navigate this environment.

Chart 1: Diverging patterns in government yields

The challenges of low and negative yields

For a Swiss-franc based portfolio, how to invest the fixed income allocation is once again a complex issue. The return to zero or even negative yields is a significant challenge, as new investments offer minimal carry income. Achieving similar positive returns to the past requires speculating on yields declining deep into negative territory, which limits the potential for returns and creates asymmetric risks. 

To solve this dilemma, portfolio managers, especially those overseeing private wealth, can take several steps. 

1. First, investing in negatively yielding bonds should be avoided whenever possible. Of course, this is not easy as the alternative is to increase either duration or credit risks, making proactive risk management essential. Exploring investments such as domestic Swiss real estate can offer an alternative and provide higher return potential, while being better equipped to hedge against the erosion of purchasing power.
2. Another option is to explore cross-border opportunities, which significantly expand the investment universe and therefore the opportunities to enhance yield. Areas with higher credit spreads, such as US dollar and euro-denominated corporate credit markets, or emerging market debt, further enhance the potential for income. Yet it is crucial to recognise the risk profile of these investments. More importantly, when venturing into cross-border investments, the question of currency hedging inevitably arises, adding another layer of complexity to the decision-making process.

Chart 2: CHF bonds performed better as capital gains returned quickly

Ultimately, it’s about knowing the asset’s role in portfolios

In general, fixed income investments are best conducted on a currency-hedged basis, as exchange-rate fluctuations can detract from coupon income and undermine bonds’ fundamental characteristics. These are providing a stable income stream and, in the case of safer bonds, delivering hedging during times of market stress. 

There are exceptions to this rule, however. For example, when non-Swiss franc based investors sometimes deliberately hold Swiss franc bonds without currency hedging, using the strong Swiss currency to add stability and hedging benefits to their portfolios. After all, Switzerland’s combination of low yields and a strong currency is no coincidence, but rather a reflection of its robust governance and political stability. This has created an ideal environment for storing value and wealth, particularly in today’s climate. 

For their part, Swiss franc investors may be willing to take moderate currency risks when investing in higher-yielding segments like emerging market debt or US dollar and euro corporate debt, because the increased yields provide a buffer against any potential adverse currency impact. Importantly, any such unhedged currency exposure should be chosen consciously, and the additional risks must be understood. Ultimately, it is crucial to consider each portfolio component in context and understand its intended role, with currency hedging decisions being paramount, especially for bond allocations.

In conclusion, Swiss franc investors facing the prospect of low and negative yields have an opportunity to capitalise on the diverse value propositions presented by different bond markets and currencies. But doing so requires a clear understanding of each asset’s role in the portfolio.

Please note: the information provided is for educational purposes only.