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Positioning across fixed income in a higher rate environment · UBS Trending

• 0:11
  Hi everyone.
• 0:12
  My name is Dan Cassidy.
• 0:13
  Welcome back to UBS trending.
• 0:16
  There is a lot on top of mind right now
• 0:18
  for fixed income investors.
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  My colleague
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  Leslie Falconio, head of taxable fixed income strategy
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  for the Americas from the UBS chief Investment Office,
• 0:29
  and I recently attended the Pimco Advisor Forum in Newport
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  Beach, California, to hear how the top fixed income mindset
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  Pimco are thinking about the current environment.
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  What's ahead, and how to position.
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  Leslie and I were invited to discuss these topics
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  with managing director and generalist portfolio manager
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  at Pimco, Mike.
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  So we had an insightful and actionable discussion about the fixed
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  income landscape, and a special thanks to the team at Pimco
• 0:59
  for having Leslie and I at their studio with Mike.
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  It was an enjoyable experience.
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  Here's the conversation.
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  Yields are quite attractive in fixed income.
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  If you take a look at starting yields in U.S.
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  treasuries of five and a quarter
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  and ten year notes,
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  which is a real yield of of almost 3% on the back
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  end of the yield curve about,
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  you know, 3.5% or so in real yields.
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  And you look at, you know, a high quality fixed income portfolio
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  that could generate yields of six, seven, 8%.
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  These are very attractive starting points.
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  And again,
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  peeling the lens
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  back a little bit further, if you look at,
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  you know, kind of starting book yields of again six seven 8%
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  and 94% correlation of five year forward
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  returns to those book yields.
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  That's a pretty high quality return.
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  That's a pretty high return for a high quality portfolio.
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  And when we think about portfolio construction more broadly, we'd
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  say whatever your allocation
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  was to fixed income
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  a couple of years ago or three or 4 or 5 years ago,
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  it should be higher.
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  I'm not sure how much higher.
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  Stylistically, we'd say
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  a decent amount higher, but
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  but actually, that's not what's taking place.
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  Folks are, you know, kind of not you know, equities have gone up.
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  Fixed income is, you know, kind of run in place a little bit.
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  And so just definitionally focus on more equities
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  than, than they do.
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  And they have in the past five years
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  and we'd say
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  all else equal, you know in a portfolio construction context,
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  you should own a little bit more fixed income
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  than less
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  especially, you know,
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  what's taking place in the repricing of yields.
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  And Leslie, with that top of mind for equity and fixed
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  income investors alike, coming off the September FOMC meeting,
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  we did see the fed hike rates by 25 basis points.
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  CIO did priced at Ed heading into the meeting.
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  So coming off of that outcome and looking ahead,
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  what is your outlook for monetary policy
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  when may we see more hikes and what are the implications
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  of a hiking environment for fixed income assets?
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  Yeah, absolutely.
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  I mean, I just want to just comment
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  really quickly on something that Mike said
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  because I think it's really important
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  people like to look at fixed income over the last five years,
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  but they didn't realize, like during Covid
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  tenure, you'll get to like 50 basis points, right?
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  35 they forget they had to normalize. Right?
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  And they
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  they think that it's going to be sort of this trend
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  and not realizing that the base back then
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  in yields is very, very low.
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  And your starting point is much higher now.
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  So when it comes to like the,
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  the fed, you know, we did anticipate a hike in September.
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  Granted we were a little bit late.
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  So we kind of we mark to market a little bit on that one.
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  But that was a very common
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  you know, at first we didn't think they were going to hike.
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  A couple months back.
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  We do think that they hike again in December.
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  But to be honest, our 2027 outlook for the fed is really,
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  inconclusive.
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  I'm going to say in a sense that at a minimum, high for longer,
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  but we still have the potential,
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  you know,
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  depending on how things develop
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  fundamentally that they could possibly cut,
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  you know, in the back half of 2027.
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  Now, when we think about how it impacts fixed income,
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  let's say hypothetically we're wrong.
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  Right.
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  And they, you know, hike several more times.
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  The fixed income market is forward looking.
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  Likes to speculate it's pricing that it.
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  So given the fact it's pricing that in really already in
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  the you know the markets and the forward curve.
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  You know that's another reason
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  why we think fixed income will do quite well
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  because it already has this very hawkish outlook.
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  But we to Mike's point and I completely agree.
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  You know the expectation is you know right now
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  given the starting point
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  that compounding income is going to be key
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  in a tailwind to total return.
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  So we have a very similar view on the fed.
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  So
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  we two
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  had a
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  view they would go in September
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  mark to market view that they would go in September.
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  And more because it didn't necessarily seem like there's
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  the inflation issue that there was back in 2022 or 2023.
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  So it didn't seem
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  as all that necessary from a inflation fighting standpoint.
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  Having said that, there are some inflationary pockets
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  which they're trying to deal with.
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  And so
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  our base case would be another another hike or two as well.
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  Simply because usually if they go once history
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  tells you, maybe they don't go just once.
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  But then there's to your point, potential inflation
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  does come down.
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  In fact,
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  if nothing happens with oil, it just follows the forward curve.
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  There's a potential we're looking at headline inflation below
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  2% sometime, you know, kind of middle of next year.
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  And we could be very well looking at at cuts again.
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  And the other thing I'd point out is yes,
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  we do have four hikes priced in.
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  And so that's all priced into the curve right now.
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  Even if we over deliver, even if you get a ten year
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  note that goes up another 100 basis points in a year.
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  So given the high quality yield on a portfolio right now,
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  you can have yields go up
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  125 basis points
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  before you start losing money in fixed
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  income over a one year period of time.
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  That is super powerful.
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  And I just think folks need to remember that
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  2022 was very different.
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  Lesley's point,
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  you're they're going to have five years of really low returns
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  or really or one year of just just really abysmal returns.
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  The market chose the latter.
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  And as a result, now we're we're really set up
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  for some some pretty decent returns in fixed income.
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  And again, in the portfolio construction context,
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  I think you're supposed to have more of it.
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  So just given that we're anticipating additional hikes,
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  and that's a view shared by both Pimco and the UBS chief
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  investment office.
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  Looking at the housing market, Mike,
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  the 30 year mortgage rate currently hovering around a 7%.
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  What are the implications
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  of additional hikes to the US housing market?
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  Well, good news and bad news is that, you know, you can't
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  you can't fall off the floor.
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  So, you know, housing activity has been, has been pretty.
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  That's been pretty slow for for a couple of years now.
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  And, you know,
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  you had this situation
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  where you had significant home price appreciation during Covid.
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  And then we had a repricing of yields after, you know,
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  the fed needed to, to respond to high levels of inflation.
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  And now so we've had an affordability issue in housing for
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  for a couple of years now that's taking activity and
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  to extremely low levels.
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  So we have,
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  you know, new and existing home sales
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  combined of about, you know,
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  kind of 4 million or 4.2 million over the last few years.
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  That's a low of 20 or 25 years.
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  And that's not adjusting for the housing stock or,
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  you know, kind of population.
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  So very, very low levels of activity.
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  And so, you know, from that standpoint, it's,
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  it's not something you're necessarily going to slow,
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  you know, so, you know, potential for
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  maybe a little bit of slowing
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  of, you know,
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  kind of nonresidential construction or some other areas.
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  But residential has not been really the area that has been,
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  the engine of growth in the economy.
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  And, at these levels of rates,
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  it will it will continue to just, you know, kind of stagnate.
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  Leslie, looking at the ten year Treasury hovering at around
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  five and a quarter,
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  there has been talk about maybe five and a half to six.
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  Where does CIO see the ten year headed?
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  You know,
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  look, this past
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  month, obviously, you know, we
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  we added a little bit of interest rate risk at 5%.
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  I'm not really worried about it.
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  And as we always say, it's not the level
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  but how quickly you get there.
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  So it was that velocity that we saw in September was quite large.
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  I mean our expectation is and we do believe,
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  you know,
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  that over the next six months,
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  interest rates will start to will decline.
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  We even think by the end of the year they'll be lower,
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  you know, but it's not so much where the next 25 basis points
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  really, or even 30 basis points is going to be
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  because as Mike pointed out before,
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  you have so much cushion within that compounding income
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  that you really have a tremendous amount of protection
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  with within your sectors.
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  I mean, right now we're staying with the high quality,
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  but we are looking for,
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  you know, back to that four and three quarter ish type level.
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  We can't guarantee it's tomorrow.
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  I can't guarantee that the next, you know,
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  trend will be up another 25.
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  But honestly I'm really not worried about it.
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  So it's given the levels that we're starting from.
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  You really just pay attention to that income.
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  And it's really going to be about the fundamentals.
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  Really depends on how long
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  this conflict
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  lasts, what inflation does
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  and what the employment, how the employment keeps trending.
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  It's stable now. We'll see what happens in six months.
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  Again,
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  our expectation is the economy starts
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  to soften a little bit six months from now.
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  So yields are probably lower for 5475.
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  Mike, another consideration,
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  top of mind for fixed income investors.
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  And Leslie,
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  you wrote about this in the latest fixed income strategist.
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  The substantial amount of debt issuance.
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  How should fixed income investors think about absorbing that?
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  How are you thinking about that?
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  Yeah, there's there's there's a lot of opportunities out there.
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  There's no there's no shortage of of debt
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  whether it's here in the United States
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  or other developed markets.
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  And it's, you know, there's competition for capital and that's
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  that's led to, to these, these high levels of yields and created
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  attractive opportunities to, to position
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  your portfolio and take advantage of.
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  So, I guess the short answer is, you know,
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  what used to be an anchor?
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  Portfolios, meaning other
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  developed markets, you know,
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  ten years ago had yields of just a handful of basis points.
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  We had 18 trillion of negative yielding debt across the globe.
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  And that was all kind of bringing us yields down.
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  You have you have global yields that are also attractive.
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  And that's, you know,
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  kind of pushing up yields a little bit in in the US as well.
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  And what we'd say to that is that's part of partly in the price.
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  And that's and that's some of the reasons
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  why US yields are where they are.
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  So we just we're finding opportunities not just here in the US
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  but globally.
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  So you know, whether it's in the in the UK,
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  whether it's in Japan, or Australia, there's other plenty of,
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  you know, kind of global duration and a diversified way to get,
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  to get some exposure that we think, that are attractive
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  and then hopefully deliver consistent returns over time.
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  What about AI related debt issuance.
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  So that's been, that's been enormous and will continue to create,
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  opportunities and portfolios.
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  We've invested in a couple of, of AI opportunities,
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  past on many more than we've invested in.
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  And I think,
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  you know, as fixed income investors, as equity investors,
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  like I said this before,
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  you know,
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  when you're investing in AI,
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  if you get three right and seven wrong,
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  you're you're in the Hall of Fame
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  and then fixed income, if you get eight right into wrong,
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  you've got some explaining to do.
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  And so we're pretty discerning from a fixed income point of view.
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  And we look at AI.
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  There are definitely opportunities out there.
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  We look to take advantage of ones
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  we can
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  shape the language, get protections
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  for our clients and get a proper spread relative to,
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  you know, some very liquid parts of the fixed income market.
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  And those do exist.
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  And when they're out there,
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  we're definitely putting them in portfolios.
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  So so again, lots to consider, lots of opportunities.
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  I think it's great for,
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  for active managers.
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  I think it's great for,
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  you know, fixed income participants
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  in general
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  have all these different opportunities
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  to build a diversified portfolio
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  to generate that attractive yield.
• 11:26
  Okay.
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  So quite a lot of opportunities out there to be mindful of.
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  But with opportunity comes risk.
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  And I do want to end on positioning preferences a bit later
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  in the conversation.
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  Before we get there,
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  let's talk about maybe some risks we haven't highlighted yet.
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  Leslie, what's top of mind for you?
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  What should fixed income investors be mindful of right now?
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  You know,
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  look there's the
• 11:46
  the largest risk right now
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  is obviously on the inflation
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  front in terms of in terms of what
• 11:50
  the performance could be for fixed income going forward.
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  I mean, one of the things that you don't want to see is,
• 11:56
  a fed
• 11:57
  that's hiking in a bear steepening,
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  right, meaning yields go up and led by that back end.
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  That's always a little bit of caution.
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  Because that could be distressing,
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  particularly if it's inflation driven.
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  So the risk to fixed income right now
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  is that inflation continues, you know, on a path that's,
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  you know,
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  you know,
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  everyone is moving higher, not just about the 2% target
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  but continues to move higher. That is not our call.
• 12:19
  We continue to believe that, you know, inflation will
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  start in this disinflation stereo again.
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  When either comes
• 12:26
  the owners will cover rent or over time
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  maybe the er productivity.
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  But right now, given
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  given the war we're seeing in the Middle East,
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  there's going to be some bumps in the road.
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  So this might be more of a 2027 kind of trend down.
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  But that's that's
• 12:40
  one of the
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  the risks, the other risk is too is
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  I think that Mike was talking about
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  is that people not appreciating the value of fixed income
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  and not appreciating that, particularly at these levels of the
• 12:52
  level of yields,
• 12:53
  what the diverse of what type of diversifier they truly are.
• 12:56
  I know they've been disappointed the past several years.
• 12:58
  We know the correlation is broken down, but it's much different
• 13:01
  when you're
• 13:02
  at the starting levels that you are today
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  than what you were several years ago.
• 13:06
  Again, a special thanks to Pimco for their partnership
• 13:09
  and collaboration.
• 13:10
  It's always a great opportunity to share, thinking
• 13:13
  and hear what's on the minds of our top industry colleagues.
• 13:17
  For more information, visit ubs.com/views
• 13:21
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• 13:23
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• 13:27
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• 13:29
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• 13:33
  And as always, if you have any questions about your portfolio,
• 13:36
  please speak with a financial advisor from UBS Studios
• 13:40
  here in New York.
• 13:41
  I'm Dan Cassidy. Thank you for joining us.