CIO Fixed Income Roundtable Series: Mid-year performance update
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Hi, everyone. Dan Cassidy here. Welcome back to the UBS Market Moves podcast channel as we are continuing today with our series of fixed income roundtable conversations with the fixed income team from the UBS Chief Investment Office. This conversation takes place

place every other month, and of course, there is a lot to catch up on. We are joined today by Sadiq Mukherjee, Frank Saleo, Barry McEllendon from the CIO Fixed Income Team, leading today's roundtable. Glad to welcome back the head of taxable fixed income strategy for the Americas, Leslie Falconeo. So with that, Leslie, thank you for joining, and let me pass it over to you to lead today's conversation. Thank you, Dan. I appreciate that, and thanks, everyone, for joining in. You know, I think this call is definitely...

at the right time given the fact that we have you know the six-month and on monday and of course we were seeing more and more uncertainty playing to the market place but with that said you know the resiliency that we're seeing from the u_s_ economy the resiliency that we're seeing from risk assets

and the equity market, and continues to surprise most investors, I believe. As most investors came into the year expecting heightened volatility, chose to take that volatility and stay on the sidelines and keep their money, say, in cash. But as we've seen, cash has actually outperformed

underperformed most risk assets. So as we sit here and we continuously debate like the soft versus hard data, the monetary policy versus the fiscal side, this debate will continue to flow during the second half of the year. But where we sit today is that we have 10-year treasury yields sitting at 425. We have the market pricing in over

close to 70 basis points of cuts just for 2025 and increasing the probability that those cuts will be pushed forward with about 30% starting in July and almost 100% starting in September and continuing through the first quarter of 2026.

It's CIO's expectation that the first cut, and this is really what we've had for several months, that the first cut occurs in September. We're expecting 100 basis points of cuts total, with that September being 25 basis points and another three consecutive 25 basis points cuts, totaling about 100 basis points, which gets us to a terminal rate of around 3.25% percent,

which is frankly where the market is right now i think really what it's a pride of most investors is the resiliency of risk assets when it comes to spread tightening and things like investment-grade corporate high-yield senior loans all these factors that were you know expected to see some volatility in the beginning of the year has have really shocked investors given that technical bid given the lower supply and that's one of the things that we're going to discuss

with what I call our three very expert analysts in terms of what sectors they believe or within their sector they believe are the best opportunities and maybe what to be cautious of. So I do want to start first with Sadiq, who actually does –

who is the head of our muni group you know he puts out some great work and some great analytics on muniside and steve i do want to start with you because you know as with other assets right that we've seen you know we've had you know municipals and although a high quality asset in the first half of the year you know struggled a little bit even though interest rates kind of went to a three seven three seven three you know 10 year low we're now at 425 but

but we've had to be patrician a little bit of struggle the first half year but with that you know that has created you know what we believe a lot of opportunity in the second half so if you could just go through some of the drivers of the under performance that we thought in the first half and why do you think things might change in terms of sentiment and relative value you heading into the end of the year sure uh... i have to give uh... my insights uh... and thanks for having me on the pollen but the very generous introduction

So let's just start with a quick recap of what's happened so far. The first half, as you mentioned, it's been a disappointing first half for munis. And across the muni complex, actually, the investment grade tax return munis tax

and high yield munis and taxable munis. The first two are actually in the red. Taxable munis, although a positive for total returns, still lags treasuries and investment-grade corporates. So overall muni performance has been disappointing. Let me focus on the investment-grade tax exempt munis. That's by far the largest segment of the market and the most important. There, the underperformance was driven really by three factors.

uh... the supply dynamic dynamics uh... elevated supply uh... record supply last year but this the fitting higher than last year and i'll go to a little bit as to what what is driving that uh... policy uncertainties the second letter the stool and finally pressure great volatility both the factors combined uh... led to the underperformance

On supply side, we are seeing very elevated supply since almost seven to eight months now. And that's the confluence of aging infrastructure, a postponement of capex during the pandemic. And now in the post-pandemic world, waning of extraordinary fiscal support,

and finally higher capex costs, driven even higher by these tariffs. So supply has to keep pace with a decade or more of underinvestment, if you will, in munis. That, coupled with the second leg of the stool, the policy, there was a lot of policy angst as the year started. There were great threats to the muni tax exemption, tariff and inflation concerns,

and then the negative impact of uncertain federal policy in many sectors as there was all kinds of effects from trying to reduce fiscal spending on states and local governments. Some of that has passed. We are probably past that.

and certainly on that on that front the good news uh... uh... the military that was left out of the one big beautiful bill more on that uh... that later so but still did enough uncertainly still in the pipeline uh... to try to keep that uncertain uh... policy angle uh... elevated and finally a pressure-rate volatility normally immunities are a rates product

much more than a spread product or a high-quality rates-driven asset class. But, at the end of the day, because of the supply and policy, we've seen munis actually diverge from the treasury market in how closely it is linked. So, all of those things led to underperformance,

in the first half of the year. Now, coming to the second part of your question, Leslie, we expect more positive sentiment in the latter half of the year. So the better half is ahead of us. There may be pockets of technical weakness in the fall where net supply may again be under pressure from weaker redemption demand and strong supply, which

which is expected to continue. But so far, after the steep April sell-off, technicals have turned distinctly positive. Fund flows have turned distinctly positive as the June-July redemption demand kicks in through these coupon and principal payments. So a much better balance between supply and demand. And then, so that should lead

to better total returns in the second half of the year. That said, I do want to point out quickly that some sectors, hospitals, are facing quite a challenging period. They've underperformed year-to-date, and the Medicaid outcome in the one big beautiful bill, which is very, very uncertain, and a totally separate

topic in of itself will keep challenging the sector, but overall a much better setup. Yields are near 15-year highs. Tax equivalent yields are particularly attractive, almost touching 7% for investors in the highest tax brackets, and if you account for state tax exemption even more in states like California and New York. So those are very, very attractive yields.

Munis are a lot steadier post-April sell-off. As I said, flows have gone positive. SMA demand is very robust. The curve is really steep, and that's been a hallmark of what's going on in the muni world

year-to-date, the steeper curve really makes those longer maturity munis more attractive, although there's still the prospect of rate volatility there. But munis are also cheaper year-to-date. So, steadier market, steeper curve, cheaper valuations

uh... and combined finally with our expectation of treasury yields to be lower by year-end all of those four things we have a constructive setup for munis for a better second half of the year let me stop there yeah thank you Sudeep and i think the one thing that you've mentioned which i think is important to emphasize is you know while you think the muni market in the second half of the year

you know will do better than the first instance and i completely agree with you by the way it even when we come to the treasury side you're gonna have these pockets of vulnerability and and what i mean what we mean by that is but in our interest rate call for the end of the year is around a four percent ten-year treasury yield we're sitting at a four-quarter right now right so it's not as though price appreciation is going to be a main driver to total returns as you pointed out to the it's really about

earning and compounding income that when you point out like fifteen-year you know differentiation those are really what the i think investors you know should really take a look at particularly since we are not looking at an environment in c_i_o_'s opinion that yes growth will slow but we're not looking for that recessionary environment and with that said even when we talk about pockets of vulnerability you know we've said this from the beginning of the year is that

Even though our outlook might be 4% at the end of the year, not very far from where we are now, that doesn't mean you're not going to have episodes where interest rates might move higher to 4.5% to 4.60%, particularly when you're in an environment where the market has a tendency to get a little bit ahead of itself as we're witnessing today just given the amount of cuts that have just recently been put into the marketplace given sort of this downturn.

the shadow fed and you know what a little bit of a lower g_p_ revision and sent to the people of the doctor but i think your point being is that even with these pockets of vulnerability the christian that you're going to get some of these yields are really going to be that tailwind total return and that kind of leads me over to you barry because you know what we when you think about a best great corporate but i know you've talked about this tremendous amount you know we've had the stability in the best great corporate market

And you've also had a really huge, large tactical demand. As we know, it's partly because of the carry that investors are earning. But I do want to ask, I mean, even though we haven't seen a lot of volatility in these IG spreads, what has been driving some of these returns? And how do you think the second half might play out, given the fact the sector has been so stable? And how much...

What we're seeing with this SLR deregulation and the tailwind to banks, this might actually impact the investment grade market going into the end of the year.

Yeah, thanks, Leslie. So the total return has been 3.7% year-to-date. 2.4% of that comes from the income, so mostly from the carry. That's a trend that we think is going to continue in the second half. I mean, there has been some price appreciation for investment grade, but it's been driven by the decline in yields in the Treasury curve, particularly the belly. So to your point, if you see modestly lower yields in Treasuries in the second half, that could be a bit of a tailwind, but

You know, nothing in terms of a large price appreciation. We think most of it will come from the carry. Oh, yeah, to your point, you know, we're in an environment of tight spreads, so 88 basis points at the index. It's only the third percentile of the past 20 years. It's only 11 basis points above the historic low or post-GFC low in spread that we saw in November of last year.

but the yield which covers slightly above five percent remained attractive and uh... similar to uh... could be mentioned that the technical environment uh... municipal side and corporates it's very manageable now uh... from a supply demand standpoint

particularly net issuance, net of maturities, and net of coupons for July and August of this summer, which is typically a kind of a slow supply period of the year anyway, net of maturities and net of coupons is expected to actually be negative. So there's going to be just reinvestment that occurs naturally. That's a supportive element from the

point of view. Supply has been consistent, but about in line with last year's total. So probably in line with about the $1.5 trillion in gross supply that we saw last year.

Again, on a net basis, that's where the delta rises a bit this year relative to last year, where the net issuance is expected to be lower and manageable. And then, you know, in terms of where companies have been issuing, they have been issuing mostly on kind of that

intermediate part of the curve. Limited issuance out, you know, 30 years, 30 plus years, it could just be obviously, you know, costs are highest at that point in the investment grade curve. But because the issuance has been the demand from pension insurance companies, you know, who want that

long exposure to balance their liabilities, that's been more than enough satisfied demand on the long end, even as maybe some other investors, like individual investors, are a bit more cautious going after out the curve, as we have been, rightfully so.

So, yeah, still expect probably that strong technicals to be a factor in the second half. That doesn't mean that it can't prohibit spreads from widening out. I think we view fair value slightly wider than where they are today, but not materially wider. I guess bottom line, as long as the economy –

is growing, albeit more slowly. Corporate profits also relatively benign, so it should be a good enough environment for investment rate companies, which still, from a balance sheet point of view, are in very strong shape.

And then just to your point about regulation, so yesterday we did have the Fed and the OCC issue a notice of proposed rulemaking regarding SLR reform. And I guess the main headlines talk about the fact that large banks are going to require less SLR.

equity capital in terms of, you know, they have large buffers of common equity tier one. If the SLR is lessened a bit, the buffer is even larger. So, you know, they could

They could potentially buy back more shares or they'll have other actions available to them, potentially extend more loans. So from an equity point of view, it's certainly been a driver. But I think what's probably not talked about a lot is actually –

This proposal yesterday actually had an amendment to the long-term debt requirement for banks as well. So globally systemically important banks are subject to long-term debt requirements. That's called a TLAC framework, total loss absorbing capital that helps ensure that they can be like resolved without taxpayer bailout. And under the proposal,

The Fed said that the TLAC requirements that apply to the GSIBs would decline by about 5% because that minimum threshold is lowered a bit. And then the aggregate long-term debt requirement would decline by about 16%. So on top of the strong technical that I mentioned earlier,

that exists in the market right now, this could be something even on top of that where the big six US banks, the G-SIP banks, they're frequent issuers in the primary market

But we still expect them to be frequent issuers just from a refinancing basis. But the fact that their long-term debt requirement stands to be lower. And again, it's still a proposal. It's subject to feedback. But pretty strong likelihood, I think, that core elements of this, including that long-term debt lessening, is something that will likely remain in place. So we still view investment-grade corporates attractively.

for its carry and very comfortable in that belly of the curve positioning. We'd be a little bit more cautious further out the curve. We think investors can really capture a good solid yield, close to 5% in the belly with potential for some maybe price gain as yields modestly decline further in time. Thanks, Barry. One of the things that you had said, and that was a great synopsis of what's

what was mentioned yesterday in regards to the SLR and I think your TLAC is a fantastic point. And one thing I want to add to that and I think it's important because people just naturally assume that if this goes through that banks are just going to all of a sudden buy treasuries. And that's not necessarily the case. So while the SLR and

you know, what we're seeing in terms of these less lower, you know, TLAC requirements might help financials and might help banks. It doesn't necessarily mean that the interest rate market, the treasury market is going to go lower, right? Because there's other avenues that they could use. And as yields come down, you know, banks probably won't want to buy lower yielding assets. So I think that's a great point, a great explanation. And just to remind, you know, our listeners, we do have a most attractive and invest in great corporates.

And as Barry had mentioned, this might not be a time for large spread compression, but the carry and the strength of the fundamentals, going into that intermediate part of the curve, we think the total return, particularly heading into most likely the first quarter of 2026, will be very strong. So thanks, Barry. I appreciate that.

Now I want to head over to you, Frank, and I know that when we talked about – when I mentioned in the beginning some of these unusual sort of market events that have occurred, whether it has been things like high yield and loans and the equity market doing better than maybe what people initially anticipated given the –

of uncertainty, given the unknowns out there. One of the sectors that have done well recently but maybe not have done well given their interest rate component has been the preferred market. And I know that this is coming off of two years of really great performance and they're very much subject to fund flows. But I'm really just curious to your take of what our view is, not just the first half, but going into the second half of the year and whether or not preferreds

The Kendo Immunity market, when we look at the relative value across fixed income that is not cheap, might be a place where relative value still exists within fixed income. Yeah, great point. Thanks, Leslie. That's a great setup too. So yeah, so here at mid-year, you bring up some excellent points. If we look at preferred performance, it's generally been muted year-to-date, stagnant.

to put it mildly, but generally in line with our expectations at the start of the year, looking for more modest or muted performance this year with returns in the low to mid single digits here at mid-year. That's pretty much what we've gotten so far. We've got year-to-date returns of about 1.5%. Now, that's comprised of actually a mild 0.5% loss for

from $25 par preferreds and a 3.5% gain from the $1,000 par. So overall, 1.5% year-to-date return, and that puts us on track for our forecast of low to mid single-digit returns for the year. And importantly, similar to what Barry mentioned about the year-to-date returns for investment grade returns,

Most of that or almost entirely of the entirety of that return has come from coupon return or the carry. Now, digging deeper into those year-to-date returns, you mentioned the volatility earlier this year, particularly as it relates to

tariff-related volatility, that had a significant impact on the preferred sector in March and April and, frankly, all financial markets. But the $25 per first were particularly impacted. We saw a pretty significant pullback in

in March with $25 par preferred down by about 3% in March and another 1% in April, materially underperforming the $1,000 par preferreds, those institutional preferreds. And that reaction and that

pattern highlights two important points. The first point relates to cross-sector correlations and the second point relates to valuations. On the first point, one theme that we've been highlighting this year is the importance of intra-sector or sub-sector

And you see the importance of that subsector diversification by just looking at those year-to-date returns. Again, 1.5% year-to-date, but that's a 0.5% loss for those retail $25 par preferreds.

which are more impacted by the fund flows you mentioned there, Leslie. And at the same time, you had a data 3.5% gain from the $1,000 par institutional preferreds. At the end of May, that divergence was even greater

with a year-to-date loss of 2.3% for the 25s and a 2.2% gain for the thousands. That was year-to-date at the end of May, so that disparity narrowed just a bit in June. But still, there are several reasons for that disparity, and one notable driver that I've been highlighting in recent reports and write-ups this year

is the fact that the $25 par prefers are generally more highly correlated to stocks. Yes, they're certainly interest rate sensitive given their very long duration, but they have a higher correlation to stocks than their $1,000 par brethren. So the sharp difference

drawdown in the S&P 500 in March and again in April had a greater impact on those retail preferreds. And that's something to think about as we consider the preferred security sector outlook from here, as we consider the higher correlation of $25 per preferreds with stocks. Preferred investors should really think about whether or not they have enough subsector diversification. It's really important. And if you're an investor getting your preferred exposure

exposure solely through a preferred ETF, you may not be getting enough $1,000 par exposure. You may be getting very little or maybe no $1,000 par exposure at all. And that's the topic of a report that I did a few weeks ago with our colleague Dave Perlman, our

our ETF expert here in CIO. The report was called Preferred Potpourri. It was published on June 5th, and we dive into the composition of these preferred ETFs in that report. So that's the first point I wanted to highlight, sort of the cross-correlation and sub-sector diversification and the importance of that. But the second important point illustrated by the performance we've seen year to date is valuation.

when we look at yields, the main reason we came into 2025 with more muted return expectations for the sector was basically relative value. Those tariff-related concerns and pullback in March and April into early May impacted performance, and they did improve valuation a bit. Preferred yield premiums rose and improved a bit during that timeframe, but they did so from an historical

low level at the start of the year. And with stronger investor sentiment more recently in recent weeks, spreads have once again tightened in a bit. So in terms of the outlook, sector valuation continues to be the most limiting constraint. There's really no catalyst on the horizon that would lead for credit premiums to materially tighten further here. For example, we don't think banks are all going to be suddenly upgraded to AAA ratings or anything like that. And although we expect the interest rate back

drop to remain favorable with the Fed maintaining a bias to cut rates. And you laid out at the start there, Leslie, our expectation is here at CIO for 100 basis points of cuts by year end. Interest rate trends are not likely to provide the same driver of returns for the remainder of the year that they did in 2024. And there's minimal

capacity and preferred credit premiums right now to provide a cushion against any drive towards significantly higher market yields for whatever reason whether that be in higher interest rates which we're not expecting or wider credit spreads which could happen i mean there is the potential for tariff related volatility to return we have this july 9th deadline that's looming so that's something to keep in mind as well on the other hand it's not all negative there

There are forces of stability out there as well.

I think you mentioned supply. We've actually seen net redemptions of preferreds from the banks. That's been very supportive for the past 18 months or two years, I'd say, and we expect that to continue. Barry mentioned that, and you did as well, the SLR reform and the banking regulatory capital reforms that are being suggested or proposed in general. That would suggest that

the support of technicals would just continue. So that's, that's a positive as well. And, and just, you know, ever,

Everyone's mentioning valuation in general. The issue of tight valuations for preferreds is not happening in a vacuum. So the lack of competitive yield alternatives would likely continue to support the preferred sector as well. And coupled with a benign rate backdrop, the sector should perform steady returns, even still low to mid single digits, but pretty steady with durable yields of about 6%. And just to wrap up, I mentioned we

We did recently publish the latest Top Picks report. It was published on June 25th. It's important to consider subsector diversification. That report has many $1,000-par recommendations from high-quality issuers, many of the big six large money center banks, as well as $1,000-par preferreds from the country's largest utilities, so high-quality issuers overall. Thanks.

Thank you, Frank. I have to say that was a really great synopsis. As all of you know, and same with Barry and Sadiq, we write a lot about correlation, diversification, because all of you contribute to our monthly fixed income strategies board. We are all really big believers in that. That was a great synopsis of correlation and diversification where

as we all have preached to our investors that everyone really needs to look at either not just chase yields, but also understand your mix between, you know, how much you have in equity and those correlation, the equity market, which might put the portfolio either with too much volatility or frankly, not enough. So that, that was a great synopsis. You know, I appreciate that. And I think that just to sum up, you know, uh,

Our view going forward is this, is that we do expect growth to slow. We're at 1.5%, fourth quarter Q of Q GDP, and we do expect yields to go to around that 4% tenure by year end. However, as everyone has pointed out on this call, there still is this level of uncertainty, so this is not a straight line by any stretch. And we're going to have those pockets of vulnerability, whether it's rising interest rates,

you know maybe you'll pocket the widening spreads but overall we still look for fixed income at the factor to perform well but knowing that even if those pockets of order really were spread widen we're not looking for material widening because we're not looking for you know a recessionary type environment but when we have those no point of opportunity you were definitely take them because again going forward it's going to be the compounding income

and carry that's really going to set the trend for your total return from now probably until the next six to eight months, given the fact that while we're not at historic types, spreads are definitely not on the cheaper side without question, but there are, you know, points or there are,

sectors that are a little cheaper than others, whether that's the muni or preferred, or even if we take the stability that IG corporates have to offer. We also have the most attractive in agency MBS, which akin to the muni market has been subject to interest rate volatility. We still look at that as an attractive sector.

And it also is earning quite at 5, 6, 5, 7, is earning a great yield for a quasi sort of government guarantee asset class. So thanks, everybody, for tuning in. And we will see you again in August, September. Thanks very much.

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