CIO Fixed Income Roundtable Series: 2024 in review
The desk's analysis emphasizes the evolving dynamics within the fixed income market as it heads into 2025, particularly influenced by recent performance reviews across key sub-sectors like Municipals and Investment Grade securities. Per the full note from UBS, the team discusses implications on asset class positioning that reflect a cautious yet optimistic outlook for the year ahead, driving strategic adjustments. With the Fed's interest rates holding steady in 2024, the anticipated shifts in municipal and corporate bond yields will be crucial in shaping FX dynamics, especially against a backdrop of potential rate adjustments. The focus now is on tactical shifts amidst this overarching environment.
What the desk is arguing
The desk frames the outlook for fixed income as increasingly nuanced, focusing on yield divergence across sectors as economic conditions evolve. The UBS Chief Investment Office highlights how sub-sectors such as Investment Grade bonds are poised for resilience due to potential shifts in interest rate policies and inflation expectations. Per the full note, strategies will likely involve navigating these yield movements to optimize portfolio performance.
Their insights suggest that the adjustments in asset class positioning are being driven by a blend of anticipated macroeconomic challenges and opportunities, especially highlighting Municipal and Preferred securities' adaptability in face of evolving interest rate expectations. Additionally, the data reflects a trend of cautious optimism as the fix-income universe prepares for potential adjustments in policy that could reverberate through related FX markets.
Where it sits in our coverage
Currently, market consensus reflects a target range for the USD/EUR at approximately 1.075, with specific firms offering varying targets for December 2026:
The desk's posture aligns closely with jpmorgan, positioning itself at the higher end of the expected range. This positioning indicates a bullish outlook for the USD as fixed income markets realign to address central bank policies and broader economic shifts.
How other firms see it
Firms such as jpmorgan and goldman are aligned with this positive trajectory, framing their targets based on a view that favors a stronger USD supported by favorable fixed income trends. Conversely, bofa expresses a contrarian stance, anticipating more subdued growth in the dollar's value amidst potential headwinds.
As market participants look to the upcoming quarterly earnings and inflation indicators, it’s critical to monitor the interrelationship between fixed income strategies and currency movements, particularly how these might influence pairs like USD/JPY and USD/AUD as they react to shifting central bank narratives.
01The fixed income outlook is cautiously optimistic with defensive positioning amid evolving interest rate environments.
02Key sub-sectors like Municipals and Investment Grade bonds show potential for resilience as they adapt to macroeconomic shifts.
03Market consensus indicates varied targets, with a prevailing bullish stance around the USD amid fixed income adjustments.
04Team at UBS emphasizes tactical approaches to capitalize on yield disparities across sectors.
Market implications
Traders should focus on the USD/EUR level near 1.075 as key economic data begins to surface, which could drive sentiment in related FX markets. Watch for adjustments around Municipal and Investment Grade bond yields, which will have ripple effects on currency movements.
Risks to this view
A reversal in fixed income sentiment, particularly if inflation surprises to the downside or if there's a more aggressive stance from the Fed than currently anticipated, could invalidate this bullish outlook on the USD. Additionally, significant geopolitical events could disrupt expected economic trajectories, impacting both fixed income and forex strategies.
ubs
Hi, everyone, Dan Cassidy here. Welcome back to the Fixed Income Roundtable Conversation Series here on the UBS Market Moves podcast channel with members from the CIO Fixed Income team joined for this podcast today to close out 2024 by Barry McElindan, Frank Saleo, as well as Sadiq Murkaji. Also joining us to lead the conversation, Head of Taxable Fixed Income Strategy for the Americas with UBS CIO Leslie Falconeo.
So Leslie, with that, I'll pass it over to you to lead today's roundtable. Thanks, Dan. I appreciate it.
And yes, today is December 5th, and it's hard to believe that we are at the last month of the year. But I just wanted to just quickly give a recap of the big picture outlook and actually what we were thinking in heading into 2024. I mean, when we entered the year, about a 385 in 10-year treasury yields, we're sitting right now at about a four and a quarter, you know, and yet we have mostly positive across the board in terms of fixed income, because again, the yields and the income and the compounding income that investors have the ability to earn within the fixed income side, you know, something that we haven't seen in a very long time.
So that tail and shoulder return, we do think continues into 2025. But in terms of our interest rate outlook, I mean, we had about a 383, 385, you know, that we had projected for the end of the year that actually, you know, ended up printing much sooner than what we anticipated. So after we had a little bit of soft employment going back to that July and some volatility that we saw in the beginning of August, our level had actually had, you know, was a bit pulled forward.
And one of the caveats that we always had in the end of the year was how the election would turn out. And now that we know, we've obviously initially had what we call a large bear steeper, which is interest rates go up, led by the back end moving higher. Our expectation was that this knee-jerker action would be not for the long term in terms of the direction of rates.
And since that time, we actually saw in November 10-year Treasury yields actually come down about 20, 21 basis points. But our overall outlook remains that we believe that the economy, while it flows, you know, GDP remains, you know, above current growth. I mean, the fourth quarter GDP, Atlanta Fed now is tracking about a 3.1 percent.
We think the consumer remains strong, but a bit more selective. And as, you know, our readers know that we do have a attractive on our equity sector, more of a neutral on fixed income, but not because we believe that interest rates are going to move materially higher in 2025. But frankly, we don't really see them moving materially lower either.
Our expectation for 2025 and 10-year Treasury yields is about a 4 percent. So we're not looking for a tremendous amount of price appreciation. And given the fact that volatility has really come down, you know, since the election, you know, we're not going to get too comfortable with that being a trend of long term.
Because as we know, you know, January 20th, when we have the inauguration, it's, you know, the policies will get a little bit more concrete views in terms of path and implementation. But the data from those policies, you really won't see hit the economy until the second half of 2025. So you're going to have a little bit more volatility, even though we've seen it wane in the short term.
And while we continue right now, it's like the higher quality sectors. And we have some really great people on say that's going to go through some of our outlook, which those that have followed our, you know, year ahead recognize that we have been more lean towards the higher quality. We have been lean towards adding a bit of interest rate risk on as yields have risen, but not going further out than, say, that five year part of the curve.
And we do think that sectors that have experienced headwinds this year, whether it's agency, MBS, and munis, you know, will probably or have the ability to recover in 2025. So with that said, I do want to start off with, with, with Sadiq, you know, I know that you just did a muni market guide and you spent, you know, you've been doing munis for, Sadiq, how long? 30 years? Yeah.
Quite long. Yeah. Quite long.
So he's obviously, he's quite an expert in that sector and he's actually done, he has produced some really great material on the muni market guide that was just, that was just published is, you know, a tremendous reference, reference point. So I just want to sort of start with you Sadiq, particularly in terms of that muni side, because we have a lot of questions that come in, particularly from our clients, you know, you know, outside of just, let's, let's first do your opinion and a recap of 2024 as a whole and how you've seen influences and things change actually since the election, you know, till now. Excellent.
And thank you, Leslie, and thank you very much for the very generous introduction. Yeah, the municipal market guide, the year 2025 was just published. So encourage all our audience to, to take a look at that.
So let me, let me just hit on the highlights for 2024. 2024 was a year of record supply, which was not anticipated at the beginning of the year that it would turn out to be this strong a year for supply, you know, pent up demand for issuance from the pandemic, you know, generally lower rates, all of that combined to produce a very strong year of supply. And as a result of that, even though the flows were pretty strong, and I'll come to that in a second in November, overall year to date returns have been on the tepid side, so to speak, but everything else but total returns are anything but tepid. You had a tremendous normalization of the curve from deep inversion to an almost near normal looking curve, strong supply balanced by strong flows.
And then finally, we had a red wave sweep in the elections. And that kind of changed the dynamic a little bit in the muni market. So November, coming to November, munis have enjoyed a tremendous rally post election.
And it's one of the best performing asset classes within the U.S. fixed income, all three segments, taxes and munis, taxable munis, high yield, you name it, very strong performance in November. That has boosted returns and munis are now outperforming treasuries. But overall, year to date returns still on the tepid side.
Which brings me to another important issue that I think Leslie mentioned, fiscal and tax policy. This is central to munis, has a very strong influence on the municipal market for good reason. And in our year ahead outlook, we say that these fiscal and tax policy uncertainties are expected to linger in 2025, especially the first half.
Some types of munis may lose their tax exemption, even though there's a lot of rhetoric around that and a lot of material being put by various sources. We feel that the effects will not be very widespread. And in any case, even if our assessment is not fully correct, existing bonds will be grandfathered.
And if that happens, their scarcity value will actually rise. So that's one impact of fiscal and tax policy. Also we have been hearing about the state and local tax reduction or SALT, as they call it, the reduction cap will be raised.
And that would mean slightly lower demand for munis in high tax states, as I think everybody knows. And that's why our particular attractive for high income owners in high tax states where there are better investment from a yield perspective, tax-equivalent yield perspective, compared to, let's say, investment-grade corporate bonds. So on the tax and policy side, while there is little doubt that fiscal deficit will be elevated in 2025 and new tariffs will be implemented, we still believe that actual outcomes will be influenced and perhaps moderated by the fiscal hawks in the Republican Party and those who remain somewhat wary of aggressive protectionist measures.
So no doubt there is uncertainty there, but we have some moderation dynamics in play there. Let me go to technicals. Technicals play a very important role in the short to medium term in munis.
By technicals, I mean the balance of demand and supply. We expect 2025 to be another year of strong supply. We are actually estimating tax exemptions in excess of 450 billion next year.
And this is a continuation of the 2024 team. Significant pent-up demands for public infrastructure investment is a key driver. And in fact, tax policy uncertainty can actually pull forward issuance in the first half of 2025.
So the first half can see a little more volatility than many investors typically expect. Having said that, we also expect inflows to remain strong. We saw one of the strongest inflows in munis in November and we expect that strength to continue in 2025 and that is supported by the Fed easing cycle.
Those two factors, both strong, which should keep demand and supply in balance. Let me add a very quick note on taxables. In contrast to tax exempt, which has seen tremendous supply, taxables continue to have relatively muted supply, spreads to the US ag are wider since April, but overall tight from a long-term perspective.
We don't see a compelling value there. One note we should add on taxables is they are a longer duration asset. So while declining treasury yields would be positive in 2025, we also caution slightly on the rate volatility is a bigger risk here than in taxable munis.
Overall, taxable, our view remains neutral. But talking about treasuries, I think Leslie alluded to this. We do expect treasury yields to be moderate further in 2025, but we remain cautious of that long end in the near term.
And in 2025, we do expect the AAA munis tax exempt munis curve to bull steepen moderately, but less so than the treasury curve. That, combined with our expectation that inflation will continue to dissipate, much remains a risk factor. The reemergence of that remains a risk factor due to tariffs and fiscal deficits.
So putting all of that together, the treasury yields and the munis dynamics in terms of positioning, we continue to like the longer end of the intermediate curve in munis, the 12 to 22 year, that is with special emphasis on the 70 to 22 year band, that that we think is the sweet spot, given the risk return dynamics here and the overall effective target portfolio duration being about six to six and a half years. And that's right about where the munis index also is. Finally, credit.
This has been a bit of a surprise. The U.S. economy has stayed strong, very robust, spending has been robust, and that has helped solidify already strong credit quality. That being said, we are at the end of, we have crossed actually the peak of upward momentum in ratings.
So we expect rating upwards to moderate further in 2025, probably an even split between upgrades and downgrades. Triple B's remain tight, high yield remains tight. So even though the caddy is good in the shorter run, we think that higher quality is the way to go from a relative value perspective.
So overall, you know, the key word is strength and that's the title of our market guide, strength amid policy uncertainties. So we expect a strong year for munis in 2025, strong supply, strong inflows, but also higher volatility as policy outcomes evolve. So let me stop.
Yes, Sadiq, so you would say, I mean, that's that's really a great summation. And I think that what you're saying is if you have a longer holding period, right, and if you can sort of go through that volatility, the yields are very attractive today. Right.
And that's what we're saying. Yeah. And I think that's really an important point.
I mean, you know, the volatility that we're going to see next year, obviously, you're going to have the bond vigilantes and those that are concerned about reacceleration inflation and possibly a slowing labor market, even though we are still looking at the soft landing. But for those who have a longer holding period return, particularly as you mentioned, those longer end maturities, you know, the yield that you're earning, we haven't seen in quite some time. Yes, absolutely.
Yeah, that is OK. Thank you, Sadiq. And so now I want to I want to switch to the investment grade.
And, you know, we've been as our people who listen to our podcast and read our publications are well aware we've had a most attractive, if you will, on on high quality, which has been the agency MBS and that's a great corporate market, which I know has kept very, very busy and very specialized as well on the financial side, which, you know, we like in the investment corporate side and our equity team likes as well. So, Barry, I just want to give the same question to you in terms of, you know, this recap of what we've seen in twenty twenty four. If there are certain views have changed after the election and how that might sort of flow into the first part of twenty five.
Yeah, thanks, Leslie. So I think, you know, one of the surprises this year is that the bulk of the return for IG has come from the coupon income. So the average coupon of the index is four point four percent and the year to date total return is five.
So you've had some modest price appreciation, but not the kind of price appreciation that we were looking for, you know, when we thought that the treasury of the 10 year was going to go down to three eighty five. You know, it did. But since it's come back, it's that coupon component which is driving the return.
And I think for most of the investment grade corporate investor base, both individuals and institutions, you know, this is quite fine. You know, we invest in investment grade corporate bonds for their higher quality, for a pickup you get over treasuries. And, you know, that pickup has been sufficient for investors this year.
Treasuries are only returning about two two point four percent this year. So obviously, valuations are a different story and spreads. You know, you're only at like your historical tights now.
It's essentially the zero percentile, you know, over really over the past 30 years, you know, since we've been tracking investment grade spreads. But the reason why we still, you know, view it to be attractive in a relative sense is that yield component. So the 5 percent yield in IG overall, believe it or not, it's you know, we started this year and the overall yield was five point one.
So, you know, the yield is not too far different. It's obviously traded in quite a range, though. You know, it was as low as four point seven, as high as five point seven.
But again, you know, this yield and on a percentile basis is close to the 90th percentile that we witnessed post GFC. So so it's this yield, you know, again, combined with spreads that are tight, but yet provide a pickup over government bonds. That's going to keep the appeal for IG intact.
That's why in CIO's 2025 year ahead outlook, we do have that attractive view. And, you know, we do expect, you know, continuation of some of the you know, continuation of similar trends to continue, obviously, you know, and you spoke about potential for volatility in the rates market. I think that will be a main driver of the price fluctuation we see in IG throughout the course of 25, much like was the case in 24.
But we do expect spreads to remain tight, you know, and that's really because we need to see a deterioration and either, you know, issuer fundamentals or supply demand technicals, I think, you know, in order for spreads to widen out. We don't foresee this, you know, taking place, you know, based on, you know, kind of the no knowns in the marketplace today. I think, you know, I just touch upon fundamentals.
Obviously, so much is going to be driven on the macro environment. We have more of a benign macro view in CIO, kind of that low two percent growth, you know, driven by still a healthy consumer, healthy corporate earnings that we think are going to grow and kind of the upper mid single digits in 25. That lends a great deal of support to issuer fundamentals for corporate bonds.
It gives corporate issuers leeway to add more debt to their balance sheets, which we think there's a good chance they'll do, especially as the appetite for M&A picks up based on the election outcomes. So, you know, they're not going to be in deleveraging mode. You know, they're going to be more incrementally adding leverage, but doing it selectively.
You know, I think certainly, you know, we could see more animal spirits evolved in the marketplace, but we're not expecting it to be anything, you know, to extreme levels taking place. I think corporates will do it selectively combined with the earnings growth should still make for, you know, a good fundamental environment. And then as it relates to supply demand technicals, yeah, much like it was the case in the municipal side, you know, gross issuance is has been very strong this year for investment grade corporates looking to tally about one point five trillion this year.
Similar projections for this that the street has for next year, one point five or a little bit higher. I think, you know, when we think about supply, though, you also have to consider net supply. We think about all the redemptions that are going to be occurring in the marketplace in twenty five plus the coupon reinvestment, you know, from the higher coupon level, much more manageable on a net supply basis, much more digestible.
We don't see that really is going to be a headwind. And then demand should persist at these high yield levels. And, you know, in particular, you know, non-U.S. investors, I think some of the foreign currency hedging costs could be dampened a bit.
So that looks to be perhaps, you know, another source of demand that could pick up next year. So, again, you know, we expect more of the same, I think, you know, expect kind of that mid single digit type returns primarily driven by the coupon income as it relates to, you know, to sectors. We're going to be paying attention, I think, to the three sectors I'll mention quickly look interesting to us.
Certainly financials. We've had this normalization of spreads. So we don't think spreads on aggregate really are going to outperform the index.
But you could see some outperformance in regional banks. I think that's where there's still some some additional, you know, normalization that could occur as the environment for banks looks to be strong in twenty five. Second sector is actually media.
Believe it or not, this is actually the widest trading sector presently. And, you know, there's just, you know, a lot of specific company actions taking place in this area. Large cable companies spinning off its cable business.
So, you know, we look for just, I think, more idiosyncratic events to take place in the media sector. And then finally, utilities. This is an interesting one where, you know, they've performed very strongly in twenty four, you know, based on the demand on the A.I. side.
We expect, you know, good performance to persist and issuance of fixed income securities, probably more so. This is in Frank's world in the hybrid securities area into next year. So I think I think those three sectors are ones that we're focused on and curve positioning.
We also like that five year part of the curve where you get benefit of duration without going out too far, you know, in maturity. Lindsay, I could turn it back to you. Yeah, that's a great, you know, that's a great summary.
And one thing that the tech that we've seen or you've seen in I.T. has been it's been pretty rough, not just for foreign demand, right? But pension funds are fully funded. You've had annuities rise.
You have insurance company demand. And you expect that, I mean, particularly given that we don't think you're going to have this large decline in interest rates heading into twenty twenty five. So you expect the technical part of demand for corporates to really flow through into next year?
That's right. Yeah. You know, this yield level, again, being high on a percentile basis, we haven't seen it in a while, you know, coupled with the ingredients for just good performance, whether it's macro, Fed easing, fundamental strong in tax.
So I think that should keep investor demand strong for I.G. That's great. Thank you.
And now I just want to sort of move down a little bit of that credit spectrum. And Barry mentioned the hybrid. And, you know, we want to go to the preferred side now.
And frankly, who who leads the preferred efforts and, you know, publishes the income, which is incredibly popular report within the chief investment officer to our clients. I listen to Frank. I know you work very hard, but let's be honest.
You've had a spotlight sector this year. OK, so so Frank. So while Frank is a very hard worker, his sector has done incredibly well this year.
So I want to ask you the you know, to similar on that same tone. I mean, what have been the drivers of recap in performance in twenty twenty four? And is there anything that we saw in November and that could alter that performance as particularly as we go over to twenty twenty five?
So thanks very much. Yeah, sure. Thanks, Leslie.
And thanks for that setup. Yeah. Yeah.
Twenty twenty four has been a great year and everything just kind of worked. Everything just went right. Everything that could go well went well for preferred this year, which is a nice change from the last few years, which has not necessarily been the case.
But all in all, preferreds have performed very well this year. Fairly steady gains month after month since April. And actually those monthly gains accelerated in midsummer as the 10 year Treasury rate dropped below four percent in early August.
And and it it kind of stayed there for a pretty long stretch of time. And that contributed to solid gains in August and September, gains to the tune of two and a half to three percent in each of those two months. But that momentum hit a brick wall in October and November as rates rose sharply in the weeks leading up to and then following the election.
The 10 year Treasury rate spiked by about 80 basis points in eight weeks, closing at four point four or five percent on November 13th. So that really abruptly ended the five month streak of gains that had begun in in May of this year. And we've had some marginal losses since then.
But nonetheless, as you mentioned, the sector has been a solid performer this year with year to date gains of about 10, 10 and a half percent. That includes an 11 percent gain for a thousand dollar par preferred and a 10 percent return for the twenty five dollar par preferred. And, you know, we came into twenty twenty four looking for gains in the upper single digits, possibly double digit returns for the sector.
And we are on track with that target range, which is pretty good. And even if we look at performance on a trailing 12 month basis, we also see strong gains in the 12 months ending November 30th. The preferred sector returned more than 14 percent.
That includes a 15 percent gain for the thousand dollar pars and 13.6 for twenty five dollar par preferred. Now, in terms of the outlook, returns from here are very likely to be much more subdued. And that's because the four pillars of support that have driven the preferred sector over the past year are not likely to provide the same degree of of tailwind that they have over the past year.
The primary drivers of preferred returns over the past year have been valuation, interest rates, fundamentals and technicals. And in the past, I've referred to these as the four legged stool of support for the preferred sector. But as we look ahead, those four performance drivers are not likely to provide the same level of support.
First of all, valuations are less attractive than they were a year ago or at the start of the year. Looking at the 10 year treasury rate, for example, the 10 year treasury today is about 20 basis points higher than where it was at the start of the year. Yet preferred yields are about 80 basis points lower.
So clearly relative valuations are just not as attractive. Secondly, the rate backdrop, it's going to remain benign. That's our expectation.
We expect rates to generally trend lower over the next year, but not materially lower, as you mentioned, Leslie, in your opening comments, not materially lower. As a matter of fact, our CIO target for the 10 year treasury yield 12 months from now is about 4 percent. So not not too far below where we are currently.
So rates are less likely to drive performance from here in the same way that they have over the past 12 months. On the other hand, the fundamentals remain supportive as the operating environment improves for the banking sector. And the latest quarterly results from the banking sector have have supported that and have shown that that's important because banks comprise a large component of the issuer composition for preferred.
And the operating environment has definitely improved given the changes in the industry backdrop and also the election results suggest a more favorable regulatory environment for banks. And then finally, technicals, technicals remain strong. Those supply demand dynamics and one of the things that has been an important trend this year has been the uptick in preferred calls and redemptions, those calls and redemptions to continue to come in at a rapid pace.
So on balance, I'd say we should expect more modest returns next year from the preferred sector, driven mostly by coupon income, similar to what Barry just mentioned with respect to investment grade. And we'll probably see more volatility in monthly returns driven by the potential rate volatility, Leslie, that you mentioned. However, there are still some opportunities to find good yield within the preferred space, particularly among discounted variable rate preferreds in the thousand dollar par market.
You know, in the wake of the pandemic lockdown period and the policy stimulus related to that time and then the Fed's historic rate hiking cycle, we broke out of that low rate interest rate paradigm we had been locked into for much of the prior decade. But now looking out over the next few years, it's very likely we're going to be in a higher relative rate backdrop overall. We'll probably have higher rates of inflation than we did in the prior decade, a higher terminal Fed funds rate.
And so the variable rate preferreds that were issued in that prior lower interest rate regime, many with lower relative coupons, are still trading at discount. They're very likely to perform well in going forward as they see their coupons reset higher and therefore supporting their prices and yields. And these discounted variable rate preferreds have offered some of the best total return opportunities within the preferred sector over the past year, and they continue to look particularly interesting.
Many of these are among the recommendations we publish each month in a report called the Preferred Securities Top Picks, and the latest edition is entitled The Four Legged Stool Revisited. So, Leslie, that's about where things stand. I appreciate that, Frank.
That was a great summary. I wanted to ask you, Larry talked about the regional side, regional banks. How do you look at that in the preferred sector as a whole?
Yeah, things are definitely looking more interesting there as well. As a matter of fact, in addition to, I would say, within the sector and in terms of opportunities, you know, that's another theme. I did mention the discounted variable rate preferreds offering some unique opportunities, but those preferreds, both variable rate, fixed rate, what have you, also are offering some interesting opportunities in that they are providing some additional yield premiums.
So, yeah, there's some interesting spots to look at there. That's great, Frank. Thanks so much.
I appreciate that. And just to, as we sort of end this month's round table, you know, in the first week or first week and a half in January, we will have our fixed income strategist out, which covers a lot of these sectors, and everyone on this call is a large contributor to that publication. And that's where we will discuss our 2025 outlook.
For that publication, we'll wait for January to actually discuss the outlook only because, as we witnessed from last year, interest rates could move at the end of the year very quickly, but we will have that out on the first week of January, and I'm sure everyone's comments that you've heard today will be in that publication as well. So, I want to wish everybody a happy holiday, and we'll see you in about a month, and thank you for everyone that participated. Thanks very much.
Thanks, Frank. Thanks, Dave, for joining us on the latest research. UBS Chief Investment Office's Investment Views are prepared and published by the Global Wealth Management Business of UBS AG or its affiliate, UBS.
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