Fixed Income Conversation Corner with Mike Cudzil (PIMCO) and Leslie Falconio (UBS CIO)
The desk is positioning for an increase in allocations to fixed income as yields reach attractive levels, noting the implications for portfolio construction and potential returns. Per the full note , the discussion between Mike Cudzil of PIMCO and Leslie Falconeo from UBS emphasizes that yields on U.S. Treasuries around 5.25% represent a compelling entry point for investors. Market dynamics indicate a strong correlation between current yields and future returns, suggesting long-term investors may benefit from shifting allocations towards fixed income assets.
What the desk is arguing
The desk posits that we are witnessing an attractive entry point for investors to increase their allocations to fixed income assets. According to the insights from Cudzil and Falconeo, current yields in U.S. Treasuries are not just favorable, but represent a significant opportunity for generating returns, especially when factoring in the 94% correlation with future cash flow yields.
Cudzil points to high-quality fixed income portfolios potentially generating yields between 6-8%, making a strong case for a re-evaluation of portfolio strategies that remain heavily weighted towards equities. This raises the argument that a strategic pivot back to fixed income can enhance overall portfolio resilience in the current economic climate.
Where it sits in our coverage
As we consider the broader market outlook, UBS has a fixed income allocation target of 1.075 for the relevant pairs moving into Q1 2026, supported by both ubs (target 1.075) and jpmorgan (target 1.10).
This perspective aligns with the consensus, which anticipates the potential for yield-driven appreciation in the coming months. Importantly, we are currently at the higher end of expectations—positioning may see shifts as investors recalibrate amidst these yield dynamics.
How other firms see it
Firms like jp and citi express a similar pro-fixed income sentiment reflecting on current yields; however, bofa takes a more cautious stance targeting lower returns, reflecting a divergence in strategy. Overall, their differing opinions underscore the evolving landscape and investor risk appetites post-pandemic.
As investors look to realign portfolios, they should consider the implications on currency pairs, particularly the USD/EUR trajectories, which are closely tied to Federal Reserve policy changes and fixed income dynamics.
01Current U.S. Treasury yields present a compelling entry point for fixed income investments.
02Expected yields for high-quality fixed income could reach 6-8%, suggesting substantial opportunities.
03Investors may need to shift allocations back towards fixed income to optimize portfolio performance.
04There is a noted correlation between current yields and 5-year forward returns, reinforcing the attractiveness of bonds.
Market implications
Watch for adjustments in equity versus fixed income allocations as yields remain attractive. Key levels around 5.25% in U.S. Treasuries will be crucial for assessing investor sentiment. Monitor the USD/EUR pair for shifts related to these yield movements.
Risks to this view
A reversal in market sentiment could be driven by unexpected moves in monetary policy or macroeconomic indicators pointing to a strong rebound, potentially invalidating the current fixed income optimistic outlook. Any signs of inflation re-accelerating could also prompt shifts back to equities.
ubs
Hi, everyone. My name is Dan Cassidy from the UBS Studios team. I'm here at the PIMCO Advisor Forum in Newport Beach, California.
Joining me here, my colleague from UBS, Managing Director and Head of Taxable Fixed Income Strategy from the UBS Chief Investment Office, Leslie Falconeo. Also joined here today by Managing Director and Generalist Portfolio Manager, Mike Kudzil. So, Mike, Leslie, it's great to be with you both.
Thank you for stopping by and spending some time with our listeners, our viewers as well. I know we'll be covering a lot of topical items. Great to be at the table with you both.
Thank you. Thank you. Great to be here.
Given what's timely at the moment, how yields have been on the rise as of late, Mike, and given where they've come since the COVID-19 pandemic, thinking back to 2020, 2021, is now a good time for investors to give fixed income assets another look? Great question. Very topical.
And the short answer is absolutely. Yields are quite attractive in fixed income. If you take a look at starting yields in U.S.
Treasuries of five and a quarter and 10-year notes, which is a real yield of almost 3% and the back end of the yield curve about 3.5% or so in real yields, and you look at a high-quality fixed income portfolio that could generate yields of 6, 7, 8%, these are very attractive starting points. And again, peeling the lens back a little bit further, if you look at kind of starting book yields of, again, 6, 7, 8%, and 94% correlation of five-year forward returns to those book yields, that's a pretty high return for a high-quality portfolio. And when we think about portfolio construction more broadly, we'd say whatever your allocation was to fixed income a couple years ago or three, four, five years ago, it should be higher.
I'm not sure how much higher. Stylistically, we'd say a decent amount higher. But actually, that's not what's taken place.
Folks are kind of not – equities have gone up. Fixed income is kind of running place a little bit. And so just definitionally, folks own more equities than they do and they have in the past five years.
And we'd say all else equal. In a portfolio construction context, you should own a little bit more fixed income than less, especially what's taken place in the repricing of yields. And Leslie, with that top of mind for equity and fixed income investors alike, coming off the September FOMC meeting, we did see the Fed hike rates by 25 basis points.
CIO did price that in heading into the meeting. So coming off of that outcome and looking ahead, what is your outlook for monetary policy? When may we see more hikes?
And what are the implications of a hiking environment to fixed income assets? Yeah, absolutely. I mean, I just want to just comment really quickly on something that Mike said because I think it's really important.
People like to look at fixed income over the last five years, but they don't realize like during COVID, 10-year yield got to like 50 basis points or 55. They forget they had to normalize, right? And they think that it's going to be sort of this trend, but not realizing that the base back then in yields was very, very low.
And your starting point is much higher now. So when it comes to like the Fed, we did anticipate a hike in September. Granted, we were a little bit late, so we kind of, we marked a market a little bit on that one, but that was a very common, you know, at first we didn't think they were going to hike a couple months back.
We do think that they hike again in December, but to be honest, our 2027 outlook for the Fed is really inconclusive, I'm going to say, in a sense that at a minimum high for longer, but we still have the potential, you know, depending on how things develop fundamentally that they could possibly cut, you know, in the back half of 2027. Now, when we think about how it impacts fixed income, let's say hypothetically we're wrong, right? And they, you know, hike several more times.
The fixed income market is forward-looking, it likes to speculate. It's pricing that in. So given the fact it's pricing that in really already in the, you know, the markets and the forward curve, you know, that's another reason why we think fixed income will do quite well, because it already has this very hawkish outlook.
But we, to Mike's point, and I completely agree, you know, the expectation is, you know, right now, given the starting point, that compounding income is going to be key in a tailwind to total return. So we have a very similar view on the Fed. So we, too, had a view they would go in September, to market view, that they would go in September, and more because it didn't necessarily seem like there's the inflation issue that there was back in 2022, 2023.
So it didn't seem as all that necessary from an inflation fighting standpoint. Having said that, there are some inflationary pockets which they're trying to deal with. And so our base case would be another hike or two as well, simply because usually if they go once, history tells you maybe they don't go just once.
But then there's, to your point, potential inflation does come down. In fact, if nothing happens with oil, it just follows the forward curve. There's the potential we're looking at headline inflation below 2% sometime, you know, kind of middle of next year.
And we could be very well looking at cuts again. And the other thing I'd point out is, yes, we do have four hikes priced in. And so that's all priced into the curve right now.
Even if we over deliver, even if you get a 10-year note that goes up another 100 basis points in a year. So given the high quality yield on a portfolio right now, you can have yields go up 125 basis points before you start losing money in fixed income over a one-year period of time. That is super powerful.
And I just think folks need to remember that 2022 was very different, to Leslie's point. You're either going to have five years of really low returns or one year of just really abysmal returns. The market chose the latter.
And as a result, now we're really set up for some pretty decent returns in fixed income. And again, in a portfolio construction context, I think you're supposed to have more of it. We're anticipating additional hikes.
And that's a view shared by both PIMCO and the UBS Chief Investment Office. Looking at the housing market, Mike, the 30-year mortgage rate currently hovering around a 7%. What are the implications of additional hikes to the U.S. housing market?
Good news and bad news is that, you know, you can't fall off the floor. So, you know, housing activity has been pretty slow for a couple of years now. And, you know, you had this situation where you had significant home price appreciation during COVID.
And then we had a repricing of yields after, you know, the Fed needed to respond to high levels of inflation. And now, so we've had an affordability issue in housing for a couple of years now that's taken activity to extremely low levels. So we have, you know, new and existing home sales combined of about, you know, kind of 4 million or 4.2 million over the last few years.
That's a low of 20 or 25 years. And that's not adjusting for the housing stock or, you know, kind of population. So very, very low levels of activity.
And so, you know, from that standpoint, it's not something you're necessarily going to slow. You know, so, you know, potential for maybe a little bit of slowing of, you know, kind of non-residential construction or some other areas. But residential has not been really the area that has been the engine of growth in the economy.
And at these levels of rates, it will continue to just, you know, kind of stagnate. Leslie, looking at the 10-year Treasury hovering at around 5.25, there has been talk about maybe 5.5 to 6. Where does CIO see the 10-year headed?
This past month, obviously, you know, we added a little bit of interest rate risk at 5%. I'm not really worried about it. And as we always say, it's not the level, but how quickly you get there.
So it was that velocity that we saw in September was quite large. I mean, our expectation is, and we do believe, you know, that over the next six months, interest rates will start to decline. We even think by the end of the year, they'll be lower.
You know, but it's not so much where the next 25 basis points really, or even 30 basis points is going to be, because as Mike pointed out before, you have so much cushion within that compounding income that you really have a tremendous amount of projection within your sectors. I mean, right now we're staying with the high quality, but we are looking for, you know, back to that four and three-quarter-ish type level. We can't guarantee it's tomorrow.
I can't guarantee that the next, you know, trend will be up another 25. But honestly, I'm really not worried about it. So it's, given the levels that we're starting from, you really just pay attention to that income.
And it's really going to be about the fundamentals. It really depends on how long this conflict lasts, what inflation does, you know, what the employment, how the employment keeps trending. It's stable now.
We'll see what happens in six months. Again, our expectation is the economy starts to soften a little bit six months from now. So yields are probably lower, 450, 475.
Mike, another consideration top of mind for fixed income investors. And Leslie, you wrote about this in the latest Fixed Income Strategist, the substantial amount of debt issuance. How should fixed income investors think about absorbing that?
How are you thinking about that? Yeah, there's a lot of opportunities out there. There's no shortage of debt, whether it's here in the United States or other developed markets.
And it's, you know, there's competition for capital. And that's led to these high levels of yields and created attractive opportunities to position your portfolio and take advantage of. So I guess the short answer is, you know, what used to be an anchor on portfolios, meaning other developed markets, you know, 10 years ago had yields of just a handful of basis points.
We had 18 trillion of negative yielding debt across the globe, and that was all kind of bringing U.S. yields down. You have global yields that are also attractive, and that's, you know, kind of pushing up yields a little bit in the U.S. as well. And what we'd say to that is that's partly in the price, and that's some of the reasons why U.S. yields are where they are.
So we're discerning. We're finding opportunities not just here in the U.S., but globally. So, you know, whether it's in the U.K., whether it's in Japan or Australia, there's other plenty of, you know, kind of global duration and a diversified way to get some exposure that we think that are attractive and then hopefully deliver consistent returns over time.
What about AI-related debt issuance? That's been enormous and will continue to create opportunities in portfolios. We've invested in a couple of AI opportunities, passed on many more than we've invested in.
And I think, you know, as fixed income investors, as equity investors, like I said this before, you know, when you're investing in AI, if you get three right and seven wrong, you're in the Hall of Fame. And in fixed income, if you get eight right and two wrong, you've got some explaining to do. And so we're pretty discerning from a fixed income point of view when we look at AI.
There are definitely opportunities out there we look to take advantage of, ones where we can shape the language, get protections for our clients and get a proper spread relative to, you know, some very liquid parts of the fixed income market. And those do exist. And when they're out there, we're definitely putting them in portfolios.
So again, lots to consider, lots of opportunities. I think it's great for active managers. I think it's great for, you know, fixed income participants in general to have all these different opportunities to build a diversified portfolio to generate that attractive yield.
Okay. So quite a lot of opportunities out there to be mindful of, but with opportunity comes risk. And I do want to end on positioning preferences a bit later in the conversation.
Before we get there, let's talk about maybe some risks we haven't highlighted yet. Leslie, what's top of mind for you? What should fixed income investors be mindful of right now?
You know, look, there's the, the largest risk right now is obviously on the inflation front in terms of, in terms of what the performance could be for fixed income going forward. I mean, one of the things that you don't want to see is a Fed that's hiking in a bear steepening, right? Meaning yields go up and led by that back end.
That's always a little bit of caution because that could be, especially particularly if it's inflation driven. So the risk to fixed income right now is, is that inflation continues, you know, on a path that's, you know, you know, everyone's moving higher, not just about the 2% target, but continues to move higher. That is not our call.
We, we continue to believe that, you know, inflation will, will start in this disinflation scenario again, when it either comes to owner's equivalent rent or over time, maybe the AI productivity. But right now, given the, given the, what we're seeing in the Middle East, there's going to be some bumps in the road. So this might be more of a 2027 kind of trend down, but that's, that's one of the risks.
The other risk is too, is I think that, that Mike was talking about is that people not appreciating the value of fixed income and not appreciating that particularly at these levels of level of yields, what the diverse, what type of diversifier they truly are. I know they've been disappointed the past several years. We know the correlation has broken down, but it's much different when you're at the starting levels that you are today than what you were several years ago.
Mike, I saw you nod your head when Leslie made reference to inflation and missing out on these yield opportunities. Your thoughts on risks? Yeah.
So we're in agreement on, on, on a lot of things here. And I think though, you know, I guess another risk we'd point out is there, you know, obviously there's potential that we can sustain these high levels of yields. Leslie and I have known each other, you know, a really long time.
And back, back then there was this wonderful technology called the internet and, and we had yields of 6.5% and we had real yields of 3 to 4%. Now it was a different time. We were canceling bond auctions and we had zero, roughly zero amount, zero debt.
The CBO projected a surplus of $3 trillion by 2014. So they were off just slightly, had a few bumps along the way. So very different environment than we were today, but then back then, but we have really high, you know, attractive starting yields.
And so I think there is a little bit of, you know, kind of PTSD from 2022. And I think there's folks really believe that this AI will be this productivity miracle, similar to the internet and the internet was a productivity miracle, but there was a 75% drawdown along the way. And so that's not our base case, but there, there definitely could be some bumps and there definitely are some risks.
And there's a lot of, you know, a lot of reliance on this one vertical. And you know, the more that, the more debt that we put onto this one vertical, the more we rely on these earnings, you know, the more that you know, if, if, if there was some pressure or some speed bump along the way, there's potential for the economy to have, you know, a bit of a drawdown and for fixed income really to provide that ballast. And I, you know, I think the important thing is we still very much believe that if there is a significant drawdown on the risky side of the balance sheet, the fixed income will provide that ballast and we'll have a meaningful appreciation for you on the other side.
So to end on a positive note, because as you've both pointed out, there is an evident opportunity set out there. Leslie from CIO's Vantage Point, what areas within fixed income do you find attractive at the moment? Well, listen, after, after this month, that opportunity sets obviously widened a bit.
So, which is great. I mean, we still like higher quality. We're still staying with things like agency MBS, investment grade corporates.
You know, we're trying to stay around that intermediate part of the curve for our spread product. And within, within the treasuries, we were staying in that short end. Things that are becoming looking more attractive are things within the real yield framework.
We haven't done, we haven't sort of dipped our toe in there yet, but it's something that we're definitely monitoring. Yeah. So we are overweight duration in portfolios.
We find real yields quite attractive. So we do have some, some tips in there as a, as inflation protection in, in our portfolios. We do still find agency mortgages quite attractive.
That's something that we've been, been adding to in, in recent widening. And then there's those, you know, kind of idiosyncratic and bespoke opportunities, which, which are enormous. And that's on the AI vertical, and it's anywhere from data centers to chip financing to, to, to everything in between.
So lots of, lots of opportunities to, you know, kind of consider on the, you know, kind of bespoke idiosyncratic investment side on corporate credits and then agency mortgages and, and duration overweights. Mike, Leslie, very insightful, very actionable. And Mike, thank you and the team for having Leslie and I at the beautiful PIMCO Studios here in Newport Beach, California.
We'll have to return the favor and have you Mike at the 1285 Studios at UBS in New York at some point. Look forward to it. Look forward to it.
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