CIO Fixed Income Roundtable Series: Mid-year performance update
The desk sees the current environment as increasingly supportive for risk assets despite growing market uncertainty, as highlighted in UBS's mid-year performance update. While many investors anticipated higher volatility and opted for cash, such holdings have notably underperformed relative to riskier assets, emphasizing a miscalculation in strategy. With 10-year Treasury yields at 4.25% and market pricing indicating expectations of rate cuts as soon as mid-2025, the stage is set for potential shifting dynamics in fixed income markets as discussed by the UBS CIO team source.
What the desk is arguing
The desk argues that the resilience of the U.S. economy bodes well for risk assets, countering expectations of increased volatility. Per the full note, the conversation among UBS's fixed income experts underscores a significant divergence between cash performance and risk assets, which may lead to reevaluation of positioning in the coming months.
Supporting this outlook, the market is currently pricing in around 70 basis points of interest rate cuts expected for 2025, including a 30% chance of cuts beginning in July, highlighting shifting market perceptions on monetary policy.
Where it sits in our coverage
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How other firms see it
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What the calendar says
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Key takeaways
01Risk assets are currently outperforming cash, contrary to investor expectations.
02The market is pricing in significant rate cuts starting mid-2025, reflecting a shift in monetary policy outlook.
03UBS's fixed income team emphasizes the need to reassess portfolio strategies in light of these developments.
04Continued economic resilience may sustain demand for risk assets in the near term.
Market implications
Traders should monitor the trajectory of 10-year Treasury yields, particularly if we see movement below 4.25%. Additionally, any forthcoming commentary from the FOMC regarding the expected rate cuts could further influence market positioning and sentiment towards risk assets.
Risks to this view
A negative shift in economic data or unexpected hawkish commentary from the Federal Reserve could unravel current bullish positioning in risk assets and revive demand for safer holdings like cash and Treasuries. Policies that induce greater volatility may also prompt investors to retreat from riskier positions.
ubs
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 every other month and, of course, there is a lot to catch up on. We are joined today by Sadiq Markerji, Frank Saleo, Barry McElinden 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 Fancotio.
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 the six-month end on Monday and, of course, we were seeing more and more uncertainty playing to the marketplace. But with that said, the resiliency that we're seeing from the U.S. economy, the resiliency that we're seeing from risk assets and the equity market 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 underperformed, you know, most risk assets. So as we sit here and we continuously debate like the soft versus hard data, you know, 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 close to 70 basis points of cuts just for 2025 and increasing the probability that those cuts will be, you know, pushed forward with about 30 percent starting in July and almost 100 percent 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-ish percent, which is frankly where the market is right now. I think really what has surprised most investors is the resiliency of risk assets when it comes to spread tightening and things like investment-grade corporates, high yield, senior loans, all these sectors that were, you know, expected to see some volatility in the beginning of the year 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 our, you know, what I call our three very expert, you know, 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 Sudeep, who is the head of our Muni Group.
You know, he puts out some great work and some great analytics on Muni side, 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 3-7, 3-7-3, you know, 10-year low, we're now at 4-25, but we've had to see a little bit of struggle the first half of the year, but with that said, 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 underperformance that we saw in the first half, and why do you think things might change in terms of sentiment and relative value, you know, heading into the end of the year? Sure.
Happy to give my insights, and thanks for having me on the call and for the very generous introduction. So let's just start with a quick recap of what's happened so far. To date, the first half, as you mentioned, it's been a disappointing first half for Munis, and across the Muni complex, actually.
The investment-grade taxes in Munis, taxes in high-yield Munis, and tax in Munis. The first two are actually in the red. Tax in Munis, although a positive total return, still lags Treasuries and investment-grade corporates.
So overall, Muni performance has been disappointing. Let me focus on the investment-paid tax in Munis. That's by far the largest segment of the market and the most important.
There, the underperformance was driven really by three factors. The supply dynamics, elevated supply, record supply last year, but this year is even higher than last year, and I'll go into a little bit as to what is driving that. Policy uncertainties, the second leg of the stool, and finally, Treasury rate volatility.
Those three factors combined led to the underperformance. On the 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, the 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 peak uncertainty on that front, so that's the good news. The Muni tax exemption was left out of the one big, beautiful bill. More on that a little later.
But still, there is enough uncertainty still in the pipeline to kind of keep that uncertain policy angle kind of elevated. And finally, we have treasury rate volatility. Normally, Munis are a rates product, much more than a spread product or a high-quality rates-driven asset class.
But here today, 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 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. 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, such as hospitals, are facing quite a challenging period of 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 and 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 percent 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. Munis are a lot steadier post-April sell-off. As I said, flows have turned positive.
SME 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, 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 while you think the Muni market in the second half of the year will do better than the first, and I completely agree with you, by the way, is that even when we come to the treasury side, you're going to have these pockets of vulnerability. And what we mean by that is, listen, our interest rate call for the end of the year is around a 4% 10-year treasury yield.
We're sitting at a 4.25% right now. So, it's not as though price appreciation is going to be a main driver to total returns. But as you pointed out, Sudeep, it's really about earning and compounding income, that when you point out 15-year differentiation, those are really what the, I think, investors should really take a look at, particularly since we are not looking at an environment, in CIO'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, 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 shadow Fed and a little bit of a lower GDP revision and sentiment being a little bit softer. But I think your point being is that even with these pockets of vulnerability, the cushion that you're going to get in some of these yields are really going to be that tailwind to total return. And that kind of leads me over to you, Barry, because when you think about investment grade corporates, and I know you've talked about this a tremendous amount, you've had the stability in the investment grade 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, 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 that the sector has been so stable, and how much, from 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 and 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 nothing in terms of a large price appreciation.
We think most of it will come from the carry. And yeah, to your point, 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 hovers slightly above 5%, remains attractive. And similar to what Tadeep mentioned about the technical environment on the municipal side, on corporates, it's pretty manageable now 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 demand point of view.
Supply's 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 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 30 years, 30-plus years could just be obviously costs are highest at that point in the investment-grade curve. But because the issuance has been the demand from pension insurance companies 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-grade 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 equity capital in terms of they have large buffers of common equity tier one. If the SLR is lessened a bit, the buffer is even larger, so 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, so this proposal yesterday actually had an amendment to the long-term debt requirement for banks as well. So globally, some of the 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 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 that exists in the market right now, this could be something even on top of that where the big six U.S. banks, the GSIB banks, they're frequent issuers in the primary market, but we still expect them to be frequent issuers just on 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, primarily 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, Bray. I think one of the things that you had said, and that was a great synopsis of 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 what we're seeing in terms of these less lower 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, because there's other avenues that they could use, and as yields come down, banks probably won't want to buy lower-yielding assets.
So I think that's a great point and a great explanation, and just to remind our listeners, we do have a most attractive and investment-grade corporates, and as Bray 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, Bray, I appreciate that. Now I want to head over to you, Frank, and I know that when we talked about, when I mentioned 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 expectation 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 can do a muni 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, Liz. 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, 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 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, most of that, or almost entirely, 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 early 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 par prefers were particularly impacted. We saw pretty significant pullback in March with $25 par prefers down by about 3% in March and another 1% in April, materially underperforming the $1,000 par prefers, those institutional prefers. 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 intrasector or subsector diversification. 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 prefers, which are more impacted by the fund flows you mentioned there, Leslie. And at the same time, year to date, a 3.5% gain from the $1,000 par institutional prefers. 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 $1,000s.
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 drawdown in the S&P 500 in March and again in April had a greater impact on those retail prefers. 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 par prefers with stocks. Preferred investors should really think about whether or not they have enough sub-sector diversification.
It's really important. And if you're an investor getting your preferred 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 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 year 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 historically 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 triple-A ratings or anything like that.
And although we expect the interest rate backdrop 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 in 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 are forces of stability out there as well. I think you mentioned supply. We've actually seen net redemptions of prefers 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 a positive as well. And just 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 the 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 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 preferreds, $1,000 par preferreds from the country's largest utilities.
So high-quality issuers overall. Thank you, Frank. I have to say, that was a really great synopsis.
And as all of you know, and same with Barry and Sadiq, we write a lot about correlation and 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 how much you have in equity and those correlations in the equity market, which might put the portfolio either with too much volatility or, frankly, not enough.
So that was a great synopsis. I appreciate that. And I think that, just to sum up, 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 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, maybe pockets of widening spreads. But overall, we still look for fixed income as a sector to perform well.
But knowing that, even if those pockets of vulnerability where spreads are, we're not looking for material widening because we're not looking for a recessionary type environment. But when we have those points of opportunity, we're definitely going to 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 tights, spreads are definitely not on the cheaper side without question. But there are, you know, points or there are, you know, sectors that are a little cheaper than others, whether that's, you know, 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, you know, quite at five, six, five, seven earns 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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