Fixed Income Conversation Corner with Adam Bloch (Guggenheim) and Leslie Falconio (UBS CIO)

Hi everyone, Dan Cassidy here. Welcome back to the Fixed Income Conversation Corner podcast series here on the UBS Market Moves podcast channel. We are joined today by Leslie Falconeo, Head of Taxable Fixed Income Strategy for the Americas from the UBS Chief Investment Office.

We're also excited to welcome his first appearance with us here on the series, Adam Block, Portfolio Manager joining us today from Guggenheim. So with that, Adam, Leslie, thank you both for dropping by, spending some time today with our listeners, our clients. Leslie, let me now turn it over to you to lead today's conversation with Adam.

Thank you so much, Dan. I appreciate it. And Adam, I know you've been on some UBS podcasts before and some trending, but it's great to have you on this series for the first time, and I'm really looking forward to getting your perspective, Guggenheim's perspective, particularly during a time where it has been tumultuous to say the least.

So thank you very much for joining. I'm looking forward to the conversation. Thanks for having me.

I feel like I've made it to the big leagues making your podcast, finally. Well, I appreciate that. Okay, so let's dive right in because I'm sure you've been asked this question as well.

I mean, I've been asked it many, many times. You know, when we think about, you know, since the end of February, right, that February 27th when, you know, growth was, slow growth is in focus, private credit, AI disruption, tenure treasury yields down to say a 394. And as we know, right after we had the conflict in the Middle East, which caused a tremendous amount of volatility within risk assets, both on the fixed income and the equity side, tenure goes to 448, you know, and spreads wide.

And lo and behold, the first week of April, we have the ceasefire, right? And then everything just like retracts. What I mean by that is the equity market makes new highs.

We've got risk assets spreads compressing, fall has come down, and everything kind of has gone, you know, pre-crisis levels, one would say, except for treasury yields. And I know we're going to talk about that a little bit more later on in the podcast, but I have to ask you, like, how do you see this, first of all, let's, what's your thought on this year-to-date performance that we've seen in spread product, number one? You know, and number two, you know, what do you think the, some of these drivers are going to be from now until year end, particularly since, as I've mentioned, you know, we've lost a lot of that vol that we've seen in March?

Yeah, it's kind of funny, you know, I think I told you that a third of the way through the year or so, we'd have the S&P up 9%, the high yield index up almost 2%. We probably wouldn't have bothered to do a podcast on that, but, you know, that obviously oversimplifies the year we've had, as you said, an enormous amount of under the surface volatility through the first four and a half months of the year. The dispersion in credit markets is particularly significant, you know, you talked about some of the volatility we've seen in rates, and I imagine we'll talk a little bit more about that, but, you know, the software story alone, which, if you remember, was the kind of, you know, entire zeitgeist and concern right up until the start of the conflict in Iran, so, you know, that, if anything, is just a reminder that active management matters, you know, the security selection, industry selection on the software side, you know, certainly in credit markets, but then risk management, you know, if you had dry powder to deploy, you know, really into anywhere other than interest rates during the onset of the war, that mattered an enormous amount, you know, in terms of what will drive the rest of the year, you know, keep an eye on Truth Social and Twitter posts, I suppose, but, you know, we think the conflict in the Middle East will continue to deescalate, that likely will not be as simple or straightforward as we think the market is hoping, so we continue to expect volatility in oil markets, though that's largely going to remain a front end of the oil market type dynamic with longer, further out on the oil curve, remaining relatively anchored, and then I mentioned earlier, but we do think the software concern is likely to come back up, obviously, we all got distracted by the Middle East, but the changing underlying dynamics in technology world, whether software or data center, CapEx related, will continue to be very significant and will drive an enormous amount of issuance, thinking about the data center side of things, so we think that will create a lot of opportunities in credit going forward.

Well, let's touch on that for a second, because I think that's a good point for a few reasons. Number one is that, you know, remarkably, if we look at, let's say, you know, your basic ICE Bank of America indices in terms of high yield and, you know, IG, spreads are kind of where we started the year, right, we're really having, they've widened a little bit, spreads kind of where we started the year, we've seen things like the CCC index and high yield compress quite a bit, to your point, you know, while the software issue or the issue with private credit, I think, is one of those that is, you know, dormant but not dead, but we still have senior loans coming back quite aggressively, you know, maybe partly because the markets, you know, put in that probability of a hike, not our call, but what is it that you think in terms of, when you think about these spread levels that we're at, how do you think about them going forward, and, you know, do you think that there's going to be volatility because of these geopolitical concerns, or is it just like, it doesn't matter really where spreads are, let's compound the income? Yeah, the last point is a good one, and, you know, as credit investors, we tend to almost exclusively focus on credit spread from a relative value perspective, and that is still how we kind of normalize the universe from a cross-sector perspective, but, you know, taking a broader view, what do investors care about?

They care about your yield, and yields are still relatively high, even with spreads at relatively tight levels, and so, you know, you look at something like high-yield credit, and that makes that a pretty attractive asset class, where you're, you know, really just thinking about what's my required rate of return to buffer me against defaults picking up or some sort of credit loss, so, you know, overall, we think we'll see likely a pretty benign credit environment for the next several months, several quarters even, you know, if you kind of look historically, you get these risk flare-ups, event-based or otherwise, credit markets, you know, react, we didn't even really get that much of a reaction in the grand scheme of things this time around, and then following that reaction, so to speak, we tend to see, you know, pretty stable returns, you know, for the next several months or even several quarters, as I mentioned. That's our kind of base case expectation. Last point I'll make is, you know, you referenced spreads being relatively tight, and that's all index-level data, but it does ignore or not acknowledge, I think, the fact that under the surface, there can be quite a bit of dispersion, so, you know, we took a look at, and we're very active in the insurance industry space within IG Corporates during the month of March, you know, you had, obviously, coming off the back of the software concerns and then the BDC market concerns that translated over into private credit, held on insurance company balance sheet concerns, and we saw some spread widening in some of the larger LifeCo life insurance names.

That provided some good opportunity to be a little more tactical, you know, even taking a relatively beta-neutral position there, but, you know, having some strong opportunity for industry and security selection, so even with spreads kind of at or near the tights in credit markets, there's still, given the volatile backdrop from a number of different perspectives, there's a lot to do to generate alpha under the surface. Yeah, absolutely, and I think that's a really good point as well, particularly when we look at the insurance side or, you know, some of those issues that has experienced a little bit more of supply headwinds than others, but as we talk about sort of like the spreads, let's switch to another performance driver in fixed income. Let's talk about, say, just the 10-year treasury.

Now, one of the things that I had mentioned is that we have this really, we have this retracement that occurred since the ceasefire that took a lot of these spreads, you know, back to pre-conflict levels, but the one thing that has stayed, that hasn't gone back, is the level of interest rates, and particularly that of the 10-year treasury. Now, we know there's some performance drivers due to that, whether it's inflation or the Fed putting, you know, or the market saying, no, Fed, you're not going to cut, you're going to hire for longer, or you might even hike, but how do you think of this 10-year treasury, even though it stayed relatively in a, you know, I would consider range-bound, what is your forecast for the 10-year as we sort of look at some of these performance drivers for fixed income, both high-quality and more credit-benefit sectors? Yeah, you kind of took the words right out of my mouth, or our firm view, which is range-bound, and it's not perhaps the most interesting view, but it does give us a number of pretty good investment implications.

So, kind of big range we've been talking about, three and three quarters to four and three quarters on 10s, realistically, we're playing that more in a 4% to 4.5% range. So, across the board, we did reduce duration back at the very end of February, as you mentioned earlier, when 10s went under 4%, began adding back duration as we kind of merged closer to 4.5% back towards the end of March. And so, you know, these are, we've kind of chalked this up to like hitting of singles, not swinging for the fences, so small little adjustments around the edge of those ranges.

But the macro backdrop, you mentioned with the de-escalation in Iran, normalizing credit markets and risk markets pretty quickly, you know, the same has not been the case for the rates market, and largely it is inflation-driven, or concerns are inflation-driven, simply because the oil market is not able to rebound nearly as quickly, which is certainly, you know, largely in part because the Strait of Hormuz is still not reopened. And as we've seen, the kind of fits and starts of trying to reopen it have been quite challenged and contested on both sides. So, you know, as I mentioned earlier, we're likely to see oil remain very volatile, and that'll keep at least uncertainty around inflation high, which means term premium is likely to remain elevated, and as a result in nominal, longer-term inflation rates should remain relatively elevated.

But what's interesting, though, you know, if you think about what oil does to inflation, that's all headline inflation. That's CPI. The Fed's mandate is core PCE, so, you know, ex-food and energy, and with a slightly different weighted basket than CPI.

Our work has headlined CPI going up by nine-tenths of a percent or so based on our forecast for oil remaining elevated here for some time, but core PCE really only going up by about a tenth of a percent. So this should not be a terribly inflationary impact for the things the Fed is officially supposed to care about, but at the very least, it will remain very difficult for them to kind of get back on the rate-cutting path in the next couple meetings, barring, you know, an immediate resolution of the conflict, which doesn't really seem that likely right now. So long winded way of saying the upward pressures on rates due to inflation are probably overstated, but at the same time not likely to have significant downward pressures anytime soon.

So again, that range-bound thesis should hold. So, you know, I want to expand on that a little bit. You partly alluded to it.

Let's first start with just the Fed for a minute. And, you know, the CPI and PCE differentiation and what the Fed and the core versus headline is noted, but, you know, at the end, you know, even when, if there is a resolution, say two weeks from now, you know, the floor on oil prices is going to be much higher than what the pre-conflict level was, right? So we have to, we also know that, you know, whether it's, you know, gasoline or whatever it might be, fertilizer, all these kinds of things are going to at some point move through the economy.

It doesn't necessarily have to be complete, you know, consumer demand destruction, but how do you think the Fed sort of looks at this through the year? And particularly since things like CPI, to your point, you know, may not be that much of an overshoot, but it has been above their target for several years. So how do you think about the Fed in terms of what the policy path will be from now to the end of the year?

So officially we have an expectation for one cut by the end of the year. I would say more realistically, that one cut is like an average of a 50% chance of no cuts and a 50% chance of two cuts. The no cuts is, you know, simply because we'll have very elevated noise and volatility around the conflict and as a result, a knock-on effect for inflation.

The two-cut side of it, though, is, you know, we are seeing significant widening in the labor market or bifurcation of the labor market, the so-called K-shaped economy that we all read about and talk about. And so, you know, we think absent this war in Iran, the Fed would be trying to war in Iran, the Fed would be trying to be cutting, you know, immediately or would have already cut once this year to try to ease the pressure on the labor market and the pressure on lower income households. But the kind of confusion thrown into it, and to your point, we haven't seen, you know, choose your favorite inflation measure, but we haven't seen any of them come down significantly enough in line with the Fed's goal.

So, you know, it does make it a tougher case for them to be cutting. The other thing that's obviously interesting is the changing of the guard at the Fed with Walsh coming in, Powell not quite leaving, leaving the chair position, but not leaving the Fed in totality. You know, Walsh probably won't be able to be as dovish as Trump had hoped given the war.

But at the same time, you know, Walsh was kind of more of a balance sheet hawk and inclined to tighten up the balance sheet. That'll also probably be difficult for him to do. Just some of the mechanics, some of the other composition of the Fed.

So we think it's likely Fed-wise going to be kind of business as usual, whatever that means, but not an enormous amount of change between now and the end of the year. And then, you know, 2027 should mean the Fed's able to kind of start to get back on the rate cutting path. But obviously, there's, you know, we've got to kind of wind down a war and see how labor market data evolves over the next, you know, the remainder of the year before we get to that point.

Yeah, I mean, you hit on the Walsh transition, and, you know, we're going to comment on that for a second. But, I mean, CIO, we have actually two cuts this year at, you know, very towards the back end of the year. But, you know, to your point, we don't have the highest conviction on that, right?

Because it is, as you mentioned, it's going to be very fundamentally driven. We just don't know what the outcome is. We don't know how long the ceasefire is going to last.

But, you know, I think what we can say with conviction, whether it's September or December or just December, we feel very confident that the next move will be a cut, not a hike. And I think that is really what the important talent is. And as you mentioned, Walsh, I just want to talk about that for a second as it relates to particularly some of the, you know, Basel III and some of the, you know, capital reforms that have been proposed.

But, you know, our view is similar to yours in terms of transition to Walsh. I mean, he might have this, these ideas of either lowering the balance sheet, although there's a big difference between lowering the balance sheet amount and just changing the composition. And we just don't feel it's going to be something that is going to be addressed for quite some time.

So we agree with that. But one of the things that you can do to try and help on the reserve side is, you know, lower bank regs, right? So how do you kind of look at, you know, this Basel III?

What are your thoughts on this? Do you think it's something that, you know, has legs to it going forward? Do you think that, how do you think this impacts sort of like the market?

And more importantly, because I know you and I, I believe, are both fans of the securitized side, particularly the agency MBS. What does this mean for, say, bank demand? Yeah, so evolution or the most recent evolutions of Basel III endgame we think are very positive, you know, both from a philosophical normative perspective, but also from a market perspective, particularly the narrowing of the scope to really just G-SIBs is important as you think about the health of kind of Tier 2 and then regional banks.

And then the enhancements that have been made to mortgage provisions are also moving in the right direction. So specifically, the update to no longer deduct mortgage balances or mortgage holdings from Tier 1 capital should do a lot to open up the bank activity there and really reduce the shifting of mortgage origination to non-bank lenders, which seems to be an overall goal of regulators. So that should be positive for the MBS market if and when it comes to fruition.

You know, we are, in terms of how we think about the direct impact on the mortgage market, you know, we have a very positive, fundamental, and technical view from a couple of different perspectives on the mortgage market, which we can talk about, not baked into that, or the bank demand increasing is not baked into those views. So we kind of view it as icing on the cake if bank demand starts to ramp up. And in conversations with a number of banks, you know, that we transact with and their treasury departments, we do get the sense that they are kind of readying the firepower to ramp up their securitization books in the mortgage market.

But it's not something we're, given the kind of fits and starts we've had on Basel III endgame over the past several years, it's not something we're ready to fully dive into from an investment thesis perspective. But the kind of trajectory or possibility is really only positive if that does come to fruition for the mortgage market. So when we think about, I mean, I know that, you know, one of our positioning has been, you know, to be long sort of that agency MBS side.

And, you know, look, they've had, last year was a great year for them. Finally, they started to kick in, right? It's a long time coming because they had really underperformed the year prior versus a lot of the compression that we saw in some of their credit card imparts, such as IG Corporates.

But, you know, we are long agency MBS. You know, we like them here in terms of the carry of current coupon. You know, the fact, obviously, the move from 598 at the end of 30-year mortgage rate at the end of Feb to say a 640-ish that we got in March and April has, you know, weighed that, you know, refinance, if you will, right?

Even though a lot of consumers are locked in at much lower rates. So what are your views on agency MBS? Do you think, I mean, some people think that they're a bit tight here.

Some people are, you know, preferring the IG Corporates over agency MBS simply because of their correlation to equity and the supplies already priced in. They believe on the IG side. And it's not like we don't like IG Corporates.

We just, we do. We just really like the agency MBS side as a great diversification within a fixed income portfolio structurally and in terms of performance drivers. But I'm curious for your thoughts.

Yeah. So I mentioned kind of a couple theses here that all triangulate around us also being very positive and overweight on MBS kind of across the board. So one, we talked about earlier, but the range about rate hypothesis or thesis means that rate refis or prepayments should remain relatively low.

If you don't think pens are going meaningfully below 4%, you know, that's really not enough of a move in the mortgage rate to incentivize a significant amount of refi. On the other hand, because you still have interest rate volatility that's somewhat elevated, you know, typical mortgage prepayment models are expecting a higher degree of prepayments than what we expect. So that means we feel like we can take risk and add exposure in current coupon mortgages and effectively get paid to take that refi risk that we don't actually end up think will, don't think will actually end up coming to fruition.

So what that means is if you look at the kind of static spread, which doesn't really assume much in the way of prepayments, you're getting paid 100, 120 over the 10-year treasury on current coupon mortgages at a time when on the IG market, you're inside 80 over. So to your point, you know, it's not necessarily a negative view on IG outright, but from a relative perspective, we think the agency mortgage market looks quite a bit more attractive. And then you throw on whether it's bank demand increasing, or as you know, if we remember back to the beginning of the year, Trump's mandate for the GSEs to buy 200 billion of mortgages that as far as we can tell, hasn't happened at all.

That's another potential shoe to drop that, you know, particularly as we approach the midterm elections that don't seem to be looking great for President Trump's party at the moment, the shift towards affordability might bring that $200 billion purchase mandate back into the spotlight. So with that, I do want to ask you, like, and please feel free to, you know, talk about various sectors that, you know, you feel offer great real value opportunity for advisors and clients, whether it's munis or preferreds or high yield, whatever it might be, but where are you, what do you think overall the position should be, you know, in this current environment? Like, what would you like to highlight?

But I also want to ask you too, as I always ask this as final thoughts, what is your, what is one of the things that the wall worry that you have, right? Because I want it to be like, what do you think is undervalued that really has the opportunity to have great tailwind to a total return? But also I'm curious as one of the things that you might be worried about in this, in the sense that, you know, the market's got a little bit too far of its keys with some of this retracement.

Yeah, absolutely. So let's start with what we like, and then we can end on the negative note of the wall of worry, I suppose. But kind of tailing off or trailing off the agency MBS discussion, there's a lot of areas of non-agency structure credit that also look very attractive, particularly in the non-agency RMBS residential mortgage backed security market.

You know, those two markets, agency and non-agency resi are pretty linked to each other. There's enough crossover buyers that kind of police the spread or the basis between the two of those pretty significantly. But then there's parts of the non-agency RMBS market that aren't particularly interest rate sensitive.

So a couple areas we really like are securitizations of HELOCs, home equity lines of credit, or second lien mortgages. And these aren't the second liens or HELOCs of the financial crisis. These are people who have a, are locked into their, you know, 50 LTVs, 3% type mortgage, who want to take out a little bit of equity to get maybe back to a cumulative 60 or 65% LTV on the house, put that money back in to do a renovation, build an addition, you know, find some way to feel like they can stay in the house without giving up their mortgage.

And these are typically 750 or higher FICO borrowers. So it's very much a different credit profile than the, you know, 0506 HELOC market. But these are not terribly interest rate sensitive collateral underlying.

Rates move 50 bits. You're not going out and refining your HELOC. You're needing quite a bit more to move the needle there.

So, but as rates rose and an interest rate ball widened, or interest rate ball rose, we saw spreads widen. And that happened in interest rate sensitive, prepay sensitive sectors, but also less prepay sensitive subsectors. So that has also been an interesting area for us to play.

And then in ABS, we continue to be very active in the aircraft ABS market as global travel continues to rebound and supply remains relatively constrained given Boeing's issues, some of the tariff related frustrations, I guess, Airbus has run into. New plane production remains very low at a time when consumer demand remains very high. And so the kind of activity in that market as a result has created some really interesting, unique opportunities for us.

But overall, we are finding a lot of value in a lot of different parts of the structure of credit markets, whether RMBS, ABS, even parts of the CLO market, given the turbulence we've had in private credit markets. And then what's the wall of worry? I think the issuance trends in the technology space are concerning, not necessarily overly concerning, but something to be very cognizant of and pay attention to.

We've been very active in financing of data center warehouses in ABS and CMBS markets over the past several years, going back three, four years when it was more of a cottage industry within structure credit. And now that market is blowing up in terms of issuance. So we're seeing ABS markets get tapped, CMBS, IG private placements, IG tradable, now high yield tradable, all to finance data centers.

And listen, the need for compute is likely to continue to grow. We all are obviously seeing AI improve our workflows and productivity, both personally and professionally. So we don't see that stopping.

But as with any commercial real estate cycle or commercial real estate buildup, you're at risk of seeing a cycle at some point. And so we're being, we think, pretty thoughtful and conservative in how we deploy capital into the technology and data center buildup. But it's something keeping a close eye on.

Well, listen, Adam, this has been, you know, this has been, I'm so glad that you came on. And I'm glad, I hope this kickstarted several more podcasts with you to come. This is a great conversation.

I'd love to hear about, you know, Duke and Heim, what they're thinking and their allocation. So thanks very much for coming on. I really appreciate it.

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