CIO Fixed Income Roundtable Podcast Series - 2Q26 update and outlook

Good day, UBS Dan Cassidy here, as we have been highlighting, we are back now with the CIO Fixed Income Roundtable Series. We're joined by members from the UBS CIO Fixed Income Team for a performance review and outlook across fixed income subsectors. Joining us here for the roundtable this month, glad to welcome back from the CIO Fixed Income Team, we have joining us Letty Zimaitis, Frank Saleo, Sadiq Merkurji, as well as Barry McElindan.

Leading today's roundtable, as always, glad to welcome back Head of Taxable Fixed Income Strategy for the Americas from the UBS Chief Investment Office, Leslie Falconeo. With that, Leslie, let me now turn it over to you. Thanks, Dan.

I appreciate it. And I'm really looking forward to today's conversation because the last two weeks within fixed income has been interesting, to say the least. Last week, the week of the 14th, we had 10-year yields rise about 24, 25 basis points.

That's the largest one-week increase that we've seen since Liberation Day. We've had the 10-year treasury yield touch of 468. That's the highest that we've seen since January 2025.

We've had 30-year yield touch of 519, which is the highest we've seen since July 2007. What is the precipitating all of this movement in treasury yields? Now, listen, we've been in this ceasefire since around the first week of April, around April 7th, so that really isn't new.

But what is continuously catching the market by surprise, and most strategists and I think analysts, is how long this ceasefire has lasted and the fact that there's really no end in sight right now. And we can go through the rhetoric that we constantly hear, that we think a deal is going to be signed and then it's not. And the market's adjusted to that.

But the fact that we've had this prolonged ceasefire, what's happening is that the market's saying, okay, even if tomorrow, hypothetically, there was a resolution, what they're pricing in for, say, the Ford oil futures, like around $80, $85, the fact that industrial moves is not just going to run smoothly, there's refineries that have to be recalibrated. We have supply chain issues and all these type of headwinds that have really been impacting the fixed income market, particularly when it comes to individuals' or investors' inflation expectations. Now, when we think about how much treasury yields have risen, and just to reiterate our view, we came into the year with the expectation that the 10-year treasury yields would stay between 4 and 4.5.

We took the opportunity, we came in a little bit short, we took the opportunity to get a little bit shorter, interest rate risk again, when the end of February occurred, and everyone was concerned about slower growth, AI disruption, private credit, and we had about a 60 basis points of cuts priced in, which pushed the 10-year treasury yield down about 3.95. Now, we started to get to 4.5% 10-year yields in March. We added a bit.

We covered that short. We added to the short end. And when we did it again this month, we started to extend some of our portfolio just a tad from the three-year to, say, the seven-year.

So now that we're seeing all these interest rates staying elevated, the market's kind of trying to decipher, is it because of inflation expectations, or is it because real yields are rising? And when real yields rise, it's because the economy is doing well, or people are simply concerned about things like the deficit. And there's been a lot of conversations about that as well.

But as a result, what we're seeing is a complete recalibration of the path of the Fed funds rate that the market is indicating. As a matter of fact, if we look at things like the March 27 contract, before this war started, it was 75 basis points of easing. Now it's 25 basis points of tightening.

That's 100 basis points move higher in about two months. So the market is completely recalibrated and saying, you know what, Fed? You're not going to ease, you're not going to stay on hold, but you're going to hike.

And just to remind our listeners, UBS CIO still does believe that there will be a cut in December of 2026. We are definitely a non-consensus view, but we maintain that view with the expectation that labor market, while solid, still remains a little bit fragile. And also we're looking for some of these headwinds to consumer demand to start to play in fruition by the end of the year.

So with that said, and all this volatility, I want to just shift to our sector experts. And Lenny, I want to start with you, because I have to say, when we think about financial conditions remaining loose and really how spreads overall have done, given the volatility that we've seen in rates and the fact that we have met some new highs, in particular the back end, a 16, 18-year high, how are you seeing sort of credit spreads play out, how the high yield and loan performance play out, and what do you see in terms of investor interest? Well, it's really quite interesting.

And the word I'm going to say is resilient, especially for high yields. They haven't been impacted so negatively with all these higher rates. If you look at their performance, they're like the second-top performer this year.

They're up 90 basis points, if you compare that to IG, which has negative performance of 20 basis points, and then they're only behind Variable Preferred, which is up 1.6. What's helping them as well is that the higher fuel prices, the energy sector represents close to 10% of high yield, and that's year-to-date up 4%, so that's very helpful for them. If you look at spreads, we have retraced.

We're back to pre-conflict levels, so spreads are at 280. At the peak in March when we were at the height of the Ivan crisis, it went to 328, but we're back to where we started the year. What has been impacted negatively within high yield is the CCC, so CCC's performance is negative.

It's down 60 basis points, and we have seen significant widening there. It started the year at 885. It peaked 100 basis points to 981 in March, and now it's come down to 940.

We recently changed our outlook for year-end spreads. We were at 320 for high yield. We cut it to 300, and it's because we've seen strong earnings within high yield.

We have solid fundamentals. There's low default rates. We're at 1.9 with our forecast being 2%, so that means not much change within the second half of the year.

Within the index, we're at much higher credit quality. Now it's double B's. It represents over 60% of the index, and if you look at over a decade ago, it was close to 35%, so it's a much higher credit quality.

Triple C's only represent 10% as most riskier bond issuances going to the private credit and that being issued within high yield. One positive thing with the higher yield is that now we have higher yields within high yield. It's at 7.2.

We started the year at 650, so it's 70 basis points higher, and the duration of high yield is three years. If you compare that to the three-year Treasury, all this increase in yield is directly coming from rates. It's not spreads.

We're historically tight spreads, and as I mentioned, we're back to where it was volatile this year. We're back to where we started. Issuance has also been robust.

We've had over 140 billion of issuance in high yield. The target based on analysts is 250, so if you analyze that, we're over the issuance. Data centers have been entering the space as well in April, which was one of the strongest April months in issuance since 21.

We had over 19 billion of issuance for data centers, and they're trading below the index, so that represents 14% of issuance. Overall issuance is 50% higher year on year, and this is due to the maturity while it's coming due in 28, so we've been seeing a lot of refinancing, which is a major driver. Also, for the second half, we're expecting maybe more M&A activity, so that will also help out issuance, and most of this issuance is all double Bs.

We're not seeing triple Cs issuing. It's more higher quality. It's all double Bs.

As you mentioned, it's been very volatile. This morning, we saw oil drop to 98. It was positive, and now we're back to 100, so if we do see that we're in the final stages of this crisis, that would help continue the momentum that we're seeing in risky assets such as high yield, and the economy will continue to grow, and then if higher oil prices do subside, that would be very supportive for the asset class.

We are neutral. Again, we're historically spread tight, so it's more a carry trade. It's not a price depreciation.

We're expecting maybe mid-single digits by year end. We would allocate to high yield at this point. It's very attractive having this seven handle, and we would do so with ETFs or mutual funds to gain exposure.

However, if it does shift and we do start seeing that we have a prolonged conflict, we might see returning to the March levels. To briefly talk about loans, loans have recovered. It started the year on the negative side with all eyes on AI disruption and obsolescence risk.

Within the sectors, there was bifurcation, especially within the software sector, which represents 14% of the index. However, we have started to be on the positive side. Prices are stabilizing.

We're seeing a pickup in issuance, and additionally, now with flows, we are at seven consecutive weeks of inflows within the asset class. Part of this could be people are willing to take a little bit more risk, but also with the Fed shifting to a more hawkish stance, demand may pick up in loans as investors would want higher floating rate notes due to the higher yields. We're neutral in the asset class.

Most sectors do have strong fundamentals, and with the elevated coupons over 8%, this also is an attractive carry for investors, and we would advise to go, again, in higher quality within the asset class. Okay, Lottie. Thanks so much, Lottie.

I appreciate that. I think one of the things that you had mentioned, which is important to distinguish, is that while high yield doesn't have as much of a negative total return as investment-grade corporates, that's actually, as you mentioned, because of one of the biggest drivers of that is that it has much lower interest rate risk, right, and if anything, you know, when we think about how tight spreads are versus what treasury yields have done, I think taking on interest rate risk as we move higher here is getting sort of cheaper and cheaper. Now, with that said, why don't we shift to a sector that does have interest rate risk, and, Frank, that goes over to you in terms of preferreds, and as we know, preferreds have had a bit of a volatile year, as with many asset classes, given the uncertainty that we've seen over the past six, seven months, whether it's, you know, the war or, you know, the Supreme Court decision on tariffs.

I mean, we've had a lot of variables going in and out in terms of interest rate vols, so how has the sector, you know, we know we've recovered after a bump in the road for a couple of months, and now we're sort of, you know, in between, I would say, so good, that sector's got a decent amount of interest rate risk, which puts it on the cheaper side, so how do you view that now, some of the drivers, and what do you think going forward? Yeah, excellent points there, Leslie. Certainly a volatile period of time, to say the least.

You know, the way I would frame it in the latest preferred securities top picks report, I wrote that the backdrop is constructive but unremarkable, so kind of like a glass half full, glass half empty type proposition. On the one hand, relative valuations are generally in line with or below historical averages, depending upon which subsector we look at, so generally a little bit more rich than cheap. Also, as we've been talking about, the interest rate backdrop this year has been, let's just say, uncooperative, definitely not a tailwind for sure.

On the other hand, you know, that is a similar proposition for most spread product, most credit markets are experiencing the same challenges with respect to rate volatility and valuations. Also, yield demand still remains very high, and supply is generally constrained, particularly when it comes to QDI-eligible bank preferreds. And also, absolute nominal yields are relatively high, so it is a good time to consider locking in those higher nominal yields, and Leti alluded to this in terms of the high yield market.

So now, drilling down into these components, starting on the rates side, most of the discussion and action lately has all been around interest rates, as we've been talking about, and as I said, you know, it's hard to argue that rates have been supportive this year. At times, they've been benign at best, but lately it's been more of a headwind, Leslie, as you mentioned. The rate on the 10-year Treasury yield closed at like 4.67 or 4.68 on May 19th, it touched 4.685 intraday, and that compares with 4.17 on January 1st, and this year's recent low of 3.94 on February 27th.

So not a lot of support from rates, and as we mentioned at the introduction, we had the largest weekly increase in the 10-year Treasury yield in a year, as you mentioned. On the valuation side, in terms of preferred yield premiums or those yield spreads, we started the yield with yield premiums below the five-year median, so really not much yield cushion to absorb the sharp rise in those benchmark Treasury rates. Last year, there were times when retail preferred yields were actually declining more than Treasury yields, especially in the third quarter, so those yield spreads were really compressing last year, particularly around the end of the third quarter, but more recently, yields on retail preferreds have climbed more than the 10-year Treasury yields rise, and so valuation has improved from last year's tight levels.

Those retail preferred yield spreads are now closer to their five-year medians, but still not a lot of cushion for significant compression of spreads among retail preferreds when we talk about yield spreads. On the institutional $1,000 par preferred side, those $1,000 par preferred yields are up less than they are in the $25 par side, so yield spreads have fallen more significantly among the institutional preferreds, and they're currently more significantly below their own five-year median spreads, so even less spread compression cushion availability there to absorb any continued rate volatility. On the other hand, $1,000 par preferreds have variable rate coupons, so much lower duration, so you are actually getting a better yield per unit duration proposition from those institutional $1,000 par preferreds.

Again, they all have variable rate coupons. Also, they're being supported. They're continuing to find significant technical tailwinds in the form of redemptions of $1,000 par bank preferreds.

Now putting it all together, what does it mean for performance this year? Well, we expect the preferred sector's performance trend to remain positive this year with somewhat volatile monthly returns, just like we've been seeing this year, but we expect overall this year those volatile monthly returns to deliver modest full-year gains, likely in the mid-single digits. Going forward, rates will continue to be the focus with a spotlight on two areas, and Leslie, you alluded to this at the introduction.

The two main areas of focus will continue to be the Fed and the Strait. The indefinite closure of the Strait of Hormuz has led to sharply elevated oil prices, and that's been wreaking havoc on inflation expectations and Fed policy expectations and having ripple effects, of course, on the benchmark treasury rates as we've seen, and that's been rippling into other markets like mortgage rates moving higher. We're now approaching the end of the third month of what has become now a double blockade of the Strait by both Iran and the U.S.

We have seen in recent days even sharp market reactions to any headlines suggesting an agreement is near, but the definitive timing of the reopening of the Strait will be key for interest rates, but of course that is just a wild card. For the Federal Reserve, the rhetoric coming out of the Fed will be highly scrutinized. The latest Fed FOMC meeting ended with three policymakers dissenting against the easing bias, which is a somewhat rare and unusual occurrence to see three dissents against the bias of the Federal Reserve Policy Committee, and that shows that there's really not a strong consensus at the Fed right now, and that was confirmed in the recent release of the FOMC minutes from that April 29th meeting.

So the speeches and the appearances of voting members, the rhetoric coming out of policymakers will continue to be parsed for any sign of direction in the months ahead. But the outlook overall, I'm expecting a coupon clipping backdrop. In addition to valuations, there are just too many obstacles in the way of more substantial returns, whether it's headwinds from tariff policy, geopolitics, surging oil prices, inflation risks, volatility will remain, and of course whenever bonds and stocks are under pressure, then prefers will get dragged down too because they're tied to both.

Now we're more than a third of the way through 2026 already. Year-to-date preferreds are up by about 0.8%, a bit more of a return from the $1,000 par preferreds. They're up by about 1.3%, a little bit less for the retail $25 par preferreds.

They're up by 0.3%, and that reflects the pullback in May. At the end of April, year-to-date gains were closer to 1.5%, 1.4%, and that probably represents a better trend line for the full year, and it gets us to mid-single-digit returns for 2026. So not too thrilling, but again, nominal yields are relatively high, so probably a good time to lock in those yields.

So Leslie, as I said at the outset, overall, glass half-full, glass half-empty. Okay. Thanks, Frank.

That was a lot there. Just to go to the sectors that are what I call not as correlated to equity but more correlated to the level of rates. So let's go to what we call the higher qualities at the sectors.

And Steve, I want to start with you because you've been on this before. You do the MediaMarkt Guide, which is a great piece, and we know that for the past couple of years, outside of this one, they've had a couple of headwinds in performance. You're doing a good job of outlining that, but I'm just curious, now that we have these higher level of rates that we're seeing and the fact that we do think the Fed cuts in December and that we think the market path is pricing in too much of a hawkish outlook, how do you think about the muni market here today and, say, over the next six, seven months?

Yeah. Happy to comment, Leslie, and thanks for having me on. Let's actually start with a quick comment on taxable munis, which is where we went attractive recently.

That's kind of an overlooked part of the U.S. fixed-income market, much smaller than the taxable munis. In the taxable munis market, roughly about 20% of the muni market, same high-quality average AA category credits, but generally longer duration. And retail investors in lower tax brackets, institutional investors, insurance companies and pension funds, they are the ones who typically invest in taxable munis.

Now, we have been attractive recently, and that was driven really by four things. It's the year-to-date underperformance, obviously longer duration, hard-hurt more. But the yield-to-worth of the indexes at 5.2% is the 87th percentile over the last 10 years.

Second point being the higher cushion as measured by the break-even increase of 61 basis points in treasury yields before a negative total return from here. And indicative of that, the yield-to-worth-to-duration ratio is at the 95th percentile over the last 10 years. It could go even higher, but that's a pretty attractive level to invest.

Unlike tax exempts, taxable munis actually have a tailwind in terms of technicals. Insurance is muted, but it used to run significantly below the 10-year average. And finally, Leslie, you talked about this in the opening, we do see a likelihood of slower growth in the second half.

All those four points combined, we think taxable munis and moderate increase in duration is warranted is a good risk-return trade-off until the end of the year or if you look at the one-year forward return. So that's the outlook on taxable munis. Coming to tax exempts, which is our main focus, we did get an attractive preference for munis.

They've been hit hard by the rate volatility, now essentially flat in terms of yield-to-date performance, but still managing to outperform treasuries, MBS, and investment-based corporates. As you said, Leslie, they had underperformed in 2025, a significantly large relative underperformance, and then the catch-up trade started working, and they have almost caught up with MBS, outperforming treasuries, and almost caught up with corporates on a trailing one-year basis. So that catch-up trade is still working despite the rate volatility.

The real main driver of the opportunity in munis is the tax-equivalent yield. It's stacked at 6.5% for investors in the highest tax brackets. That's 213 basis points over treasuries, 146 basis points over MBS, and 121 basis points over corporate.

And that spread over corporate is at the 88th percentile over the last 10 years. So munis are, from a tax-equivalent perspective, cheap. That doesn't always come through when you look at just pure ratios of the nominal yields.

We are still in a challenging technical environment. Supply is going strong, higher than last year, which was a record year. But we do expect the technicals to improve over the summer as seasonal redemption demand kicks in.

So that could be a bit of a tailwind from here. One interesting thing is, in contrast to treasuries, where long duration has systematically underperformed, tax-equivalent munis, the belly has underperformed, both short and longer duration. The belly was rich coming into the year, and the barbell is still working.

And in terms of our strategy, we still think the barbell is appropriate, takes advantage of the steep curve, has defensive ballast in that short end, available to redeploy if yields go up further. Rate risk is elevated, and munis have negative convexity. The duration extends in a rate sell-off, exacerbating the price performance.

But a lot of hawkishness is already priced into markets right now. As you said, oil conflict is key. Oil prices, all of those macro things that Frank outlined, they remain risk factors.

And I'll end with this. One interesting thing about the muni market, it has been the strong flows into the market, record flows of 38 billion has come into the market, led by ETFs, also open and mutual funds. Some of that has helped kind of battle this rate volatility.

And if rates spike further, those flows can turn. But overall, at this point, the risk-return trade-off till year-end and one-year forward return is quite attractive, especially on a tax-equivalent basis. Great, Steve.

Thank you so much. I mean, listen, you know, you're correct. And when you look at things at tax-equivalent yields, they are incredibly attractive, and there's no question there.

But there are some, you know, like with other sectors, some potential technical headwinds in the short term. And that's why we advise clients on looking at these sectors, particularly when you decide the point is to have a long-term investment. These are not sectors that you trade in and out of, you know, every three weeks, but they're really there for the long-term, you know, they serve their purpose.

And obviously, given the fact that what you're getting in a tax-equivalent yield really says it all. So thanks very much for that, Steve. Now, to you, Barry, I want to, you know, look, Barry, investment-grade corporates, you know, it's one of those, obviously, given the rate move is definitely been a headwind to performance to that sector.

But when it comes to spreads, it's astonishing, you really haven't moved. So what are your thoughts there in terms of, you know, the recent performance? And you know, when will they widen, if at all?

Yeah, thanks, Leslie. So right, spreads, not surprisingly, as Leti said, high-yield spreads back to, you know, pre-IRAM levels. So are investment-grade corporates at 75 basis points.

So four basis points tighter on the year. The total return for investment-grade, though, is about negative 20 basis points because the price loss of 2% fully absorbed 1.8% in income. I think one thing that is doing well, though, that the investment-grade corporate market is functioning very well on a new-issue basis, we've seen the hyperscalers be able to fund into U.S. dollar bonds, you know, very well, $107 billion year to date.

So it's functioning well fundamentally, technically. I'm thinking about fundamentals, you know, the earnings, too, how robust we've been. And I know fundamentals is a broad topic, but when you think about the EBITDA growth for kind of non-financial companies, that's a key metric we look at, exceeding the debt growth of these companies.

So we have EBITDA growth coming in, high single digits, debt growth, low single digits. So that's a recipe to keep, you know, leverage in check for corporates. But really, it's supporting investor comfort level in IG corporates.

And you know, the asset class, despite the total returns that have been volatile, that have been affected by treasury yields, it is positioned well with yields that are historically high, so we're at 5.2% for the IG index as a whole. We're very close to 5% for one-to-10-year investment-grade corporate maturities. You know, on a percentile basis, when you look back 10 years, you're at like the 75th to 80th percentiles in terms of yield.

Even looking back 20 years, you're still pretty high, 60 to 70 percentile. So you know, clearly we're in a strong yield environment, tight spread environment. But I still think that IG corporates are positioned pretty well, you know, given that the overall backdrop is one in which we do think that, you know, the Fed, as you mentioned, you know, have a non-consensus view that more likely to ease than tighten.

And with growth being kind of steady in the U.S., really not too hot, not too low, that's kind of a perfect range, you know, for credit, you know, not to really overheat or to become victim, you know, of, you know, of more problematic fundamentals. Investors definitely, you know, comfortable with the overall composition of the market with BBB-rated debt really coming down to the low 40 percent range. Recall just a few years ago, BBBs were over 50 percent.

So you now have a market, and part of this has been through the influx of technology bond issues that are, you know, more highly rated in the A and AA categories. But you have a BBB slice in the market that's down to about 43 percent, even like the lower rated BBB is down to about 7 percent. So yeah, you know, overall market composition, you know, looks pretty solid.

So we do find it to be a good place to take incremental risk, you know, let's say out of the short end, three-month Treasury bills at 3.6 percent, whereas these IG yields, you know, are approaching 5 percent, around 5 percent. So that differential is actually the highest that we've seen since late 2022. So, you know, we do think it's opportunistic to lock in these higher yields, you know, into an asset class that we still think certainly going to be sensitive to the overall rate environment, but, you know, from just more of a longer maturity or longer time horizon perspective, we think it's a good opportunity, you know, to lock in these yields.

So yeah, you know, with investment-grade credit, you know, we have a neutral stance overall, but we do, you know, find the carry to be attractive. I think within the market, you see value on that short end, and also the belly. So really that kind of encompasses a one- to ten-year kind of intermediate type IG maturity range.

And, you know, think about even like three- to five-year BBBs, you're getting 5 percent plus yields, you know, within that segment. So, you know, that would be an area that we would focus on. And in terms of sectors, we still like the banks.

I think the fact that they're not trading rich to the overall market is really something that could be viewed more as an opportunity, because, you know, we view the bank sector as one that is still, you know, in good financial health and one that is pretty much not immune to AI disruption risk, but one that's not in the epicenter of it. So see value, you know, in the financials, trading a bit in line with the overall IG index. And within non-financials, I think one sector that kind of stands out to us providing some opportunities is actually in utilities, where they trade wide to the IG index as well, but, you know, we see, you know, some high-quality picks that we offer within our research publications in that sector, and even within their high-bid securities, some opportunities there.

So I don't think, unfortunately, we're not going to ever be in a situation where we're not sensitive to what's going on in the treasury market, but I think, you know, as I mentioned, overall, the IG market functioning very well and kind of providing really, you know, the basis, whether it's the funding needs for companies or the income needs for individuals, you know, really providing that in a strong way. Thanks, Bray. I appreciate that.

That was really a good synopsis. And I know that we're running a little bit long, but I just wanted to just quickly recap. Overall, we're fairly pleased how we've played in terms of positioning, particularly on the interest rate risk side.

I mean, we've gone above, recently, our cap of that, our supposed top of 4.5, but that is not surprising, given the fact that the market has moved not only just for higher for longer, but they have moved to a hike with a 75% chance of a hike in 2026 and a full hike into 2027. We don't expect a lot out of the June Fed meeting. We do expect them to drop the easing bias that they had at the last meeting, which was really on teetering as it is.

And we do anticipate the Fed still cuts in December, given the fact we have real negative real wage growth, personal savings are low. And we think that the employment, while stable, does have sort of this umbrella of fragility. So we don't think it's time to, you know, we wouldn't short rates here.

We would take advantage of some of the yield plays that we talked about. Obviously, it's best to keep a diversified portfolio, remain in the, say, to the three to intermediate part of the yield curve. We're not willing to work quite yet to go full and to the back end, unless it's a longer term hold.

And obviously, diversification, as simple as the sound, is the best key to success. So thanks very much, everyone. And I look forward to our next roundtable in two months.

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