Adrian Knoblauch and Simon Lustenberger welcome us to the headquarters of Zürcher Kantonalbank in Zurich. Both have many years of experience in the fixed income market. In this interview, we survey the bond analysis process and the current fixed income environment.  

Fabrice: Hey Adrian and Simon, thank you for taking the time. Could you explain to us in a few words what you do in your job at ZKB?

Adrian: With pleasure. I work on the fixed income sell-side at ZKB and I'm responsible for the fixed income coverage of Swiss industrial issuers. We publish our opinions in written rating reports.

Simon: I manage the investment strategy for private clients on the buy-side and specifically in the area of fixed income.

Let's start with a general question. How is the current geopolitical uncertainty affecting the fixed income market?

Simon: Geopolitical risks influence the fixed income market, especially when they change the big picture, for example inflation. Local conflicts do not generally have a major impact on financial markets. However, if energy prices rise, for example, this often leads to rising yields. This then leads to falling bond prices. The Middle East conflict in particular has so far been very isolated and has had little impact on the fixed income markets.

Adrian: In the case of Swiss issuers, the impact is heavily dependent on how the uncertainties affect global demand, impact global trade and cloud the economic environment. Furthermore, many Swiss issuers were able to leave Russia fairly easily after the outbreak of the Ukraine conflict because only a few issuers had a significant local presence, and the Russian market was mainly served from abroad. However, such a scenario would hardly be the case in China. Around 20% of demand for Swiss industrial issuers comes from China and there is typically an even greater dependency in the value chain on Chinese suppliers.

Have you noticed that investors are increasingly investing in bonds?

Simon: In many regions, including outside Switzerland, it is now becoming more attractive to invest in bonds. The real yields that remain after adjusting for inflation are now positive. This was different in the low interest rate environment when the central bank bond buying programs (QE) kept yields low. Although increasing government debt and rising expenditure for example for the energy transition will keep longer term yields elevated, it remains overall a more attractive environment, partly because the risk premium in the equity markets has become lower.

Do you think that this attractiveness of the CHF debt capital markets will continue in the future?

Adrian: Generally, the times with negative yields were not easy for fixed income investors. Nevertheless, in comparison to the USD- and EUR-market, the CHF debt market had the advantage that bond yields were not affected by the manipulative measures of the central bank. Hence, the credit risk premium was not distorted by a QE-program. This made the market comparatively attractive because investors were not crowded out by central bank purchases. Since the pandemic the market has though changed a lot. Yields now look much more attractive. Although the demand for Swiss franc bonds from pension funds and institutional investors is typically high, which keeps yields and credit risk premiums generally low. Another difficulty in the market is the low liquidity of certain bonds.

Simon: The financial markets can change quickly. In recent months, there was a sharp rise in yields until the end of October, then a fall in November/December. The relative attractiveness can shift quickly. At the moment it may be attractive to invest in bonds, this could change if return prospects for the equity markets rise.

Let's move on to a company-specific question. How do you at ZKB analyze bonds and advise institutional clients?

Adrian: We assign ratings to issuers similar to Standard & Poor's, Moody's and Fitch, based on our assessment on the business and financial risk profiles. As a credit analyst, it is very important to keep an eye on the risk aspects, because the upside of your investment is limited, but the downside can be significant in the event of any deterioration in credit quality. Therefore, in our assessments we focus on typical credit risks such as indebtedness, liquidity, coverage ratios. In our analysis, we also make certain adjustments by adding pension fund obligations or off-balance sheet items to the overall debt of an issuer. Generally, my job is to provide investors a clear overview of an issuer's creditworthiness.

Does that mean you focus more on the asymmetric profile of bonds compared to equities?

Adrian: Typically, fixed income investors are active in the primary market for a new issue and then hold the bond for a longer period. Hence, my focus is on identifying risks and giving clients clear indications on the likelihood of these risks to materialize in the future.

Simon: My perspective is more geared towards collective investments for private clients, where diversification is more important. We are guided by leading indicators such as the ISM index in the USA and adjust our positioning in government or corporate bonds accordingly.

Is the current focus more on government or corporate bonds in this economic phase?

Simon: Corporate bonds have performed well so far, but if interest rates remain high, the real economy will show signs of slowing down. As long as the economy performs well, we hold an above average share of corporate bonds, but these preferences can change during the cycle.

Would it be advantageous to buy a ten-year US government bond now that interest rates are so high?

Simon: In general, yes, with buy-and-hold you have guaranteed yield unless the US government defaults. But an investor must regularly assess the relative attractiveness depending on the market situation taking the currency impact into account. The decision to hold or sell a bond is a constant evaluation.

Are there differences in approach between institutional investors and private investors when holding bonds?

Adrian: Yes, there are differences. Until recently, it made little sense for private investors to be active in the bond markets due to negative interest rates. Typically, private investors also hold bonds until maturity and usually prefer well-known issuers, hence the term household-names. On the other hands, institutional investors typically have different incentives and time horizons. For instance, a pension fund seeks a reliable stream of income that is known in advance in order to carry out his liability matching for future pension obligations.  

Simon: By the way, it was still possible to earn money with bonds even when interest rates were negative. Among other things, this was possible with steep yield curves, which resulted in a price gain. To compare private and institutional investors: precisely because private clients usually have a smaller volume than institutional clients, it is much more worthwhile for them to invest in collective vehicles.

Let's move on to Credit Suisse. What impact did the write-down of its AT1 bonds by Finma have on the Swiss bond market?

Adrian: This write-off has made investors aware of the risks to which such bonds are exposed. Of course, the write-off had a negative effect on the AT1 market in general and recalibrated the investors perception towards these instruments. In order to regain confidence, it required bellwether names such as HSBC to issue AT1-bonds in the EUR-market to restore investor confidence. UBS also recently issued AT1 bonds. The high demand has shown that the initial shock has passed.

Have you seen a shift from public capital markets to private debt?

Simon: That is a regional question. In the USA, there are of course more companies that can refinance themselves on the public capital markets. In Europe, by comparison, the proportion of bank loans is higher.

Thank you very much for the interesting insights, Adrian and Simon!

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