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

The global bond selloff has opened up more possibilities for investors to generate income from credit, but UBS is advising against seeking out the highest yields at the long end of the bond market. UBS is adopting a more tactical approach to duration following a surge in interest-rate volatility and a significant flattening of global yield curves in late August.

However, UBS does not view credit as outright bearish, as spreads have remained relatively stable, allowing investors to selectively harvest income. The key concern is that the bond selloff has not yet led to a widespread spike in credit spreads, but rising spread volatility in long-dated investment-grade bonds and high-yield debt indicates growing investor nervousness about longer maturities.

UBS anticipates a critical turning point when the U.S. 10-year Treasury yield nears 5%. A further rise beyond this level, particularly if markets start pricing a genuine Federal Reserve hiking cycle instead of a short-term "insurance-style" increase, could make it increasingly challenging for credit markets to stay insulated from rising rates.

UBS also warns about the surge in AI-related bond issuance, as increased supply of debt combined with higher compensation demands for duration risk makes the long end less appealing. UBS's strategy is defensive, suggesting profits in U.S. high-yield bonds, moving up in quality, and favoring three- to five-year investment-grade bonds worldwide.

The bank also recommends cash over synthetic credit exposure and European credit over U.S. credit. UBS's model identifies the European front end as particularly attractive after recent monetary policy adjustments. In the U.S., investment-grade bonds with three- to five-year maturities meet UBS's criteria due to lower spread volatility and declining correlation with equities.

For investors who combine cash with credit exposure, UBS advises reducing U.S. high-yield exposure in the same maturity range and increasing allocations to global investment-grade debt. UBS's derivatives-only model suggests trimming iTraxx Main exposure, taking profits in iTraxx Xover, reallocating toward CDX High Yield, and retaining a short position in emerging-market credit.

UBS also cautions about positioning, noting that credit exposure via CTA strategies is already stretched, and a volatility surge fueled by negative news could prompt systematic investors to cut long positions or even turn short, especially after a two-standard-deviation move.