Fixed Income Conversation Corner with Alex Obaza (T.Rowe Price) and Leslie Falconio (UBS CIO)
The desk reads the current fixed income landscape as favorable for fixed-income investors, aligned with sentiments from T. Rowe Price and UBS that are echoed in their recent commentary. As noted by Leslie Falconio and Alex Obaza, the performance of fixed income has outstripped expectations, particularly with yields becoming more favorable, indicating a robust comeback for this asset class (per the full note source). A notable trend highlighted is the declining volatility, which allows for greater investor confidence and positions fixed income as attractive relative to other asset classes.
What the desk is arguing
The current fixed income environment presents promising opportunities for yield-driven strategies. As Leslie Falconio from UBS mentions, there's significant movement in yield trends this year, a marked improvement from previous years where bonds faced challenges in the market. This resurgence suggests renewed interest and investment in fixed income assets.
Yields have shown positive momentum recently, with discussions around a potential return to yield-driven investment strategies, affirming that bonds are indeed experiencing a rebound. In the first two months of the year, declines in volatility have contributed to a more favorable atmosphere for fixed-income investing and have exceeded initial market expectations.
Where it sits in our coverage
Not currently applicable as there is no internal coverage data on relevant currencies.
How other firms see it
The prevailing view among some firms appears mixed, with certain analysts echoing sentiments of strength in fixed income while others remain cautious. This divergence hints at varying interpretations of market data.
Factors like central bank activities and economic indicators will influence how different firms position themselves, especially as key benchmarks could shift. Pay attention to relationships between fixed income performance and broader currency trends, as these could become tied to interest-rate movements and central bank signaling.
01Fixed income yields have improved, signaling a positive shift in investor sentiment.
02Declining volatility supports a more favorable landscape for bonds.
03The commentary indicates a strategic move back to yield-focused investments.
04Firm opinions vary, which could influence market positioning.
Market implications
Traders should watch the evolution of fixed income yields closely, especially as more data emerges about economic indicators affecting central bank policies. A firm break beyond the current yield levels might set the stage for increased allocation into this asset class.
Risks to this view
Any reversal in the current yield trend, potentially spurred by unexpected economic data or central bank actions, could challenge the positive outlook for fixed income. Additionally, a resurgence of volatility could dampen investor enthusiasm and pull capital away from bonds.
ubs
Hi everyone, Dan Cassidy here, welcome back to the Fixed Income Conversation Corner podcast series right here on the UBS Market Moves podcast channel. For today, our conversation will feature you a performance check on the asset class. We will spend some time on positioning, touch on monetary policy, thoughts on rates, among some other timely topics within the asset class.
Joining us for today's conversation, glad to welcome back Leslie Falconeo, Head of Taxable Fixed Income Strategy for the Americas with the UBS Chief Investment Office. We're happy to have back with us here on the podcast from our partners at T. Rowe Price, Alex Obeza.
Alex is a Portfolio Manager with the T. Rowe Price Fixed Income Group. So with that, Leslie, Alex, thank you both for spending some time today with our listeners and their clients.
Leslie, I'll now pass it over to you to lead today's conversation with Alex. Welcome back. Thank you, Dan.
I really appreciate it. And thank you, Alex, for joining on. I mean, this has been, this is a great time to have you on, so we're really looking forward to the conversation.
So I appreciate you taking the time. Sure. Yeah.
Thanks for having me. Let's sort of, you know, get right into it. We're almost at, we're in the last week of the second month of the year.
You know, we've had a lot of, and we have a lot of unknowns that have occurred, particularly over the past month, but we have things such as volatility continuing to trend lower. You know, when you look at the first two months of the year, you know, in your opinion, how has fixed income performed overall versus what you expected and what are some of the trends that you're seeing? Good question.
And like you said, there's certainly a lot going on right now. You know, I think that the first major thing that I can identify this year is that, you know, yield is working within fixed income. I think the slogan, it was two or three years ago, it was bonds are back, right?
And we've kind of moved away from that. But you know, if you look through the first two months of this year, fixed income, it's been a really good complement to broader equity exposures, right? So if you look in the U.S. at least, the S&P 500's up 2% this year, NASDAQ's flat, small caps are down about 2%, but returns across fixed income, you know, across different fixed income strategies have largely been positive, right?
And so, you know, positive return implies, you know, you're getting positive, you know, fixed incomes performing pretty well on a risk adjusted basis, which in my opinion should be the case for the foreseeable future. We'll talk more about monetary policy later, but, you know, point number one, fixed income is working as it should right now. And I think that will continue.
A few other things that stand out to me that I think are worth mentioning. The second, you know, I would say is the wall of worry for the market is steepening. And that's mainly a function of valuations that have tightened.
You know, we might get into this a little bit later. You know, total returns have been strong this year, but excess returns across fixed income have been a little more mixed, still some positive in there. You know, spreads are flat year to date and since inauguration day.
And I think that really reflects the market that is priced in a lot of good news and is demanding a lot more from, you know, corporate America and the economy in order to see further outperformance. And if I could sneak in one final one, and this is a little more nuanced within fixed income, but I think this is an important one, right? So the nature of fixed income performance has changed a little bit as the yield curve has normalized.
And you can actually really see that in the year to date period. So if I look across just hero prices, fixed income strategies, the top 10 performers year to date, only two of those names were in the top 10 performers over the three year time period. And what's really been happening is, you know, longer duration strategies have performed better this year as the yield curve has normalized.
Whereas over the past three years, it was front end fixed income that was performing really well. And I think this is a key thing to focus on because this is one area where I think the market may have gotten a little complacent, right? And I don't think this necessarily has to be the case going forward.
You know, front end yields should be fairly range bound with the Fed on hold here, and we can talk about that more later, where the long end might be a little bit more vulnerable, especially with the rally we've seen recently. I would actually agree with that 100%. You know, let's go into the Fed.
As we talk about the shape of the yield curve, let's kind of go into the Fed for a second. And by the way, we also believe that that short end is going to be fairly anchored. I mean, you know, with the effective fund rate at about a 433, we don't see the two year yield, you know, moving, you know, in our opinion, moving sustainably above that simply because we don't believe the Fed is going to hike.
Now, our view has been, and again, there's varying degrees of opinions on this, and, you know, there's, we're seeing some, obviously some differences in the data versus, you know, versus what we're seeing in retail sales, but it's our view that the Fed does cut twice this year in the second half of the year. But we know that the market, you know, as of this morning, you know, priced in pretty much the same thing, but it's got a little more dovish over the past week. But what do you, what's your view on the Fed, and sort of which range are you thinking about?
Are you in the, they cut camp, they hold, they hike? What are you thinking about over at T. Rowe?
Yeah, I think this is one of the more challenging ones to answer right now. So, you know, rewind, when we talked over the summer, you know, I said it made sense, I thought then for a mid-cycle adjustment, you know, a gradual reduction in rates over several years, you know, the insurance hikes that we've seen before that have really helped markets. And so, you know, we got that, but instead of it being spread over a couple years, it was pretty much jammed into one quarter.
You know, and I think that's one reason we saw rates rise after the Fed started cutting, which might have surprised some folks, you know, they really adjusted very quickly. And so where does that leave us today? You know, I'd say the Fed is only marginally restrictive in an environment, you know, I still think we're a trend or maybe a little bit better growth.
I know there's been some crosswinds recently, but still trend or better growth, and, you know, fiscal policy is growing, I would say, increasingly uncertain. So where this leaves us as far as what I think the Fed's going to do, you know, I don't think they have much room to do more mid-cycle adjusting, if I can make that a verb. You know, I think what we're really looking at is where the tails of either zero or multiple cuts is increasing.
And so the scenario where we see zero, we've seen that before this cycle, right? The market gets concerned over growth, convinces itself we're going into a recession, and then the economy powers through. I still think that is very much on the table for this year.
The case where we see multiple cuts, and so this would be more than the two that are in the dot plot, is, you know, this is the uncertainty that's introduced by fiscal policy, right? Tariffs, taxes, and immigration. It's unclear the ultimate impact on growth.
There are some scenarios I could see where we would see multiple cuts in the second half that goes further than the dots. And so the way I sum that up, you know, as investors, you know, we don't focus on certainty, you know, it's impossible to predict the future with absolute certainty, but we deal with probabilities, right? And so the probability of those tails are growing, and I think it's important to position your portfolio for those environments.
With that said, and I think you brought up a great point, and I know that you were talking about earlier the shape of the yield curve, right? And we know, and as you pointed out, you know, we went through a very long period where the yield curve was inverted and holding cash or cash alts to be able to earn that carry that you had the ability to sort of out-carry, if you will, further out the curve, and that take a lot of interest rate risk on. But as we know, the yield curve has normalized that cash, and starting the year isn't the same as it was starting in 2024, but we're also dealing with, as we spoke about earlier, a lot of spread compression within risk assets.
So how do you sort of see this? What are your thoughts on this? What are your thoughts on the spread compression that we've seen and these cash alts that people should look at, given the fact we have an open-sloping yield curve?
Yep. Yeah. So two main things that I'd highlight about spread compression, and it's certainly been a challenging environment to invest in in fixed income, given where risk markets are.
But first I'd reiterate, you know, spreads are quite tight across multiple fixed income asset classes, right? This is, you know, the wall of worry the market must climb has gotten steeper, because the bar for success is certainly higher. Again, if we rewind to the summer, I think it's interesting to see how this has played out.
Over the summer, the market talked itself into a recession, at least the rates market. We priced, you know, seven cuts, and the economy then powered through in the back half of the year as the earnings and jobs market remained fine. But, you know, we've now fully priced that with spreads where they are.
And so it's interesting, you can start to see some signs of pushback, but I think it's really important to understand the type of pushback we're getting. So, you know, year to date, we've seen some widening in corporate credit spreads across a variety of sectors, autos, manufacturing, and utilities are three that have underperformed the most. Now, what's important about this is this is not a traditional risk-off.
You know, it's not just cyclicals getting thrown out and all the defensives rallying, but it's very story-specific, right? Autos and manufacturing, probably more tariff-related, utilities, you know, it's been driven by what we've seen in California. And so this is really what happens when everything, when you're priced for perfection, everything needs to go well, there's opportunity for pockets of volatility.
But the key is it's not a traditional risk-off. It's not, you know, everyone, you know, moving to the exits. It's more, you know, if this sector, if these credits can't perform, you are vulnerable there.
And I think that's a healthy thing for markets right now, although it can be a little unsettling when you're coming off a period of spreads being very tight. The market can get a little complacent to volatility, and so it can be noteworthy. But I think it's a healthy thing for the market.
So that's point one. You know, point two I would make with the spread compressions, yeah, the yield curve is normalized, and that has affected performance recently, but it's still somewhat flat, right? And so when you look at the amount of yield you pick up to go from, say, a short-term fixed-income strategy to a full IG corporate strategy or a full high-yield strategy, you're still not getting a significant amount of yield pickup, and a lot of that is because of spreads that have tightened, to move out the curve into those, we'll call those higher-octane strategies.
So I think, you know, front-end fixed income, we talked earlier with the two-year probably being range-bound, that helps protect you there. And just with the shorter duration in front-end, you're protected from any spread widening, more so than if you were in longer strategies. You touched upon some of these.
Listen, there's a lot of uncertainty out there, as we know, and, you know, there's a lot of constant rhetoric from the administration, and, you know, but I'm curious how you view, not just the tariff immigration deregulation doge, whatever it might be, or even the refunding, right, from Bessett recently, and even some of the Bessett comments from last week. How do you see that? So what are the implications, you think, of fixed income, and how do you see that playing And also, is it already priced in?
Like, when you talk about how the autos have been impacted in the IG market. So what are your thoughts there? It's a good point.
We obviously spend a lot of time talking about it. I think there's two main points here to make. There's kind of the micro, and then there's the, like, let's back up a step and understand the bigger picture here.
So, you know, briefly, I'll highlight what I see as the main three issues that could impact the growth outlook in risk markets this year, right? And that's tariffs, taxes, and immigration. So on tariffs, as you said, you know, the buzzwords are uncertainty and lack of clarity.
We're not sure where it's going to end, but the range of outcomes is growing, right? And that introduces uncertainty. You know, if you don't know what it's going to cost to bring your product into the country, you're going to think twice about, you know, opening that proverbial new factory.
And so what we do know, you know, is there's increased uncertainty due to tariffs. That is certainly a concern for the market. Taxes, I think this is one that's a little underappreciated by the market right now.
You know, a tax cut extension without proper funding, I think traditionally the markets say, OK, tax cuts, that's growth supportive, that's good, risk on. I'm not so sure. Given the deficits we've been running since COVID, you know, if we were to extend tax cuts and not have some sort of proper or adequate amount of funding alongside that, I'm not sure the markets would react very positively.
I think that's a risk for spreads. And I also really need to think, you need to think about, you know, a money market account yields around 4, 4, 4, 5 right now, a short term, you know, an ultra short fixed income account yields around 5%. If we are increasing fiscal deficits through cutting taxes and not paying for it, does it make sense that the 10 years should yield less than money markets?
And I think that's, you know, it goes back to what I said earlier. I think the market's getting a little complacent on the long end. And I think that's one that's certainly not priced by the market right now.
Again, it's not a certainty, but it's a risk that's out there. I would just finish up on just on immigration. I would just say, you know, post COVID, I think immigration was a real positive.
It helped heal the labor market and it boosted growth. If we had a prolonged turnaround in immigration flows, I would just say it's an uncertain growth impact. But I think there will be a growth impact.
So if you put those three things together, right, there's other policies going on and we'll learn more, of course. But if you put those three things together, the broader umbrella of uncertainty encompassing, you know, the new administration's policies is growing. It could certainly be temporary.
You know, we could be looking back six months from now and say, hey, all this all ended up really well. But from where we stand right now and what we know right now, uncertainty is growing, right? And that's a tough thing in an environment that's priced for perfection.
Yeah, and I think the difficulty with that, too, is uncertainty is growing, but volatility really doesn't seem to, is not reacting so much, right, whether it's the move index or interest rate fall. Which, again, I think, too, which really leads to my next question, which you actually touched upon a bit in terms of, you know, the steepness of the wall of worry and, you know, the pocket of vulnerability. And, you know, I think that you hit a bit upon this in terms of your outlook that, you know, that back end might be a little bit underpriced.
You could get a little bit of a bear steeper, maybe decoupling with the equity and fixed income correlations. But what sort of pockets of vulnerability do you see? Is it that?
Is it tightening financial conditions? Like, where do you, outside of the fact that we're starting at a relatively low level of vol and a relatively tight level of spreads? Yeah, that's exactly it, right?
It seems, you know, corporate spreads are a good place to start, right, that we seem, we're not at the all time tights, but we're at extremely tight levels. That's somewhat a function of yields, but that means the market could be getting complacent to actual, you know, growth risks that are out there. You know, stability breeds instability.
We've had a lot of stability the last few years. And like I said, the market's talked itself into recession on more than one occasion, only to see the economy power through. That doesn't mean we have to go under recession at some point, but it does mean the market seems to be a little bit asleep on the potential for something along those lines to become priced in.
Just to be more specific, your outlook, for example. What do you like, like, in terms of, like, your final thoughts in terms of sectors that you like more than others? I mean, how do you, how do you sort of, like, want to leave your point of view with our audience?
Yeah, so the most important thing I would say right now is, in this type of environment, again, we deal with probabilities, not certainties. In this type of environment where uncertainty is growing and we could, you know, see the market take either fork in the road, this is the type of environment where you need to find ways to, I think, to put insurance in your portfolio. So you want things that will perform well across a variety of scenarios, and specifically things that will perform well and provide you liquidity in scenarios where maybe the world, you know, the market's throwing you a curveball.
So the number one takeaway, and it's what we're doing in our portfolios today, is how can you put insurance into your portfolios to build flexibility? That's kind of the high-level view. I think within that, you know, we're seeing some opportunities within agency MBS.
You can still get yields over 5% for, you know, durations that are less than five years. I think CLOs are still interesting. And then finally, under the insurance area, I think certain treasuries.
I know it's not the most exciting thing in the world, but again, you know, the front end of the yield curve, you make a two-year at, you know, around 4.2%. You know, you're not giving up a ton, you know, versus what you could go get in a fully loaded high-yield strategy. And I'm not saying put your entire portfolio into that, but I'm saying, you know, it's a good time to be thoughtful about what type of insurance can you put into the portfolio to build resiliency if we do see some of those downside scenarios.
Right. And I think, Alex, that's very similar to actually what we're thinking as well. I mean, we've kept the intermediate part of the curve around that.
Anywhere around that, say, five-year area, we've definitely maintained the high quality. We also like agency MBS as well. And I do think, to your point, that, you know, throughout the year, there's going to be these – there's going to be pockets of vulnerability, which will also bring opportunity, you know, whether it's high-yield widening.
We're expecting – you know, we don't expect a recession. We're not expecting a hard landing. We're not expecting stagnation.
So, I do think that, you know, to your point, right now, things are relatively tight. Stay with the higher quality and don't overextend in terms of interest rate risk is, I think, a strategy that our advisors can really resonate to. So, I thank you so much for coming on, and I really appreciate the conversation.
And I know the next time we speak, some of those unknowns are going to be known. So, it should be an even more exciting conversation as well. So, thanks, Alex.
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