Top of the Morning: Fixed Income Strategist - Reaching for yield
The desk argues that the performance dynamics in fixed income markets are set for increased volatility as 2025 approaches, particularly reflecting the anticipated reactions to economic data post-government shutdown. Per the full note source, the focus is on higher-quality bonds that have outperformed in high yield sectors, primarily due to shifts in Federal Reserve policy and market sentiment surrounding interest rate movements. Market participants should note that the expectation of a Fed rate cut could further influence these trends, with added market volatility likely to manifest ahead of upcoming data releases.
What the desk is arguing
The desk frames this as a critical moment for fixed income assets, where the implications of recent government shutdown resolutions and Fed rate expectations will dictate market performance leading into Q4. Investors are particularly focused on higher-quality bonds, which have shown resilience and potential for yield enhancement as risk appetite shifts.
Supporting this assertion, the UBS report highlights that the longest government shutdown has concluded, resulting in a backlog of economic data that will soon surface. The expectation of volatility rising from recent lows is significant, particularly in the context of fixed income as interest rates are poised to react to shifting fiscal conditions and Fed policy signals.
Where it sits in our coverage
Our consensus target for fixed income assets is 1.075, with a range from 1.04 to 1.12. Notably, firms in the market include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
This view aligns with jpmorgan, expecting upward momentum and a stronger yield environment, while it diverges from bofa, which maintains a more cautious stance at the lower end of our target range.
How other firms see it
Group-aligned firms, such as jpmorgan, are optimistic about yield performance reflecting Fed dovishness and a favorable backdrop for higher-quality bonds. In contrast, bofa presents a more conservative outlook on yield potential.
Key indicators to monitor include upcoming economic data releases, which will directly affect investor sentiment and could impact the trajectory of interest rates and bond markets alike.
01Increased volatility expected in fixed income due to government shutdown resolution.
02Higher-quality bonds likely to outperform as yield dynamics shift.
03Investor sentiment is significantly linked to anticipated Federal Reserve actions.
Market implications
Watch for market reactions around the year's end as economic data comes out in quick succession, potentially influencing bonds' performance and leading to volatility spikes. The positioning of higher-quality bonds could provide strategic entry points ahead of potential Fed rate adjustments.
Risks to this view
A less dovish Fed stance would undermine expectations for a rate cut, causing a significant reversal in bond yields and potentially pressuring higher-quality bonds. Unexpected adverse economic data could also detract from current yield expectations.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will continue with our series of fixed income conversations as we will spend some time highlighting the latest fixed income strategist report from the UBS Chief Investment Office.
The title for the month of November, Reaching for Yield. Joining me for the conversation today, glad to welcome the publication's contributors, Leslie Falconeo, Head of Taxable Fixed Income Strategy, as well as Letty Zimidas, Fixed Income Strategist, both from the UBS Chief Investment Office. With that, Leslie and Letty, thank you both for dropping by today to spend some time with our listeners and our clients.
I know we have a lot we want to cover today on the episode, so let's dive right into it. Leslie, it is hard to believe that we are quickly approaching year end. With that in mind, what factors do you anticipate will shape fixed income performance throughout the balance of Q4?
Yeah, absolutely. Thank you for having me, Dan. Well, I mean, there's two major factors.
I mean, obviously, you know, we finally have the end of the government shutdown, which has been, you know, the longest in history. So, we're going to have a lot of data coming our way in a very short period of time. Now, our expectation going into the fourth quarter was that volatility would rise from very low levels.
I mean, the interest rate fall had hit the lowest level that we've seen since 2022. And we also have had spread volatility that's been actually quite contained. So, our expectation that vol would go up, and this was prior to the shutdown.
So, now that we have the shutdown and now the reopen, we're going to get a lot of data. The second thing is obviously what the Fed does in December, which, you know, we do believe that they cut. But on that note, the market is continuously becoming more skeptical.
And what I mean by that is prior to the October FOMC meeting, there was about a 99% probability price dip that the Fed would cut. Post the FOMC meeting, there was a 68% probability the Fed would cut in December. Today, it's a coin flip, 50-50.
So, it keeps coming down. And one of the reasons why this is happening is that there's a lot of, you know, a bit of conflict within this data. I mean, obviously, we have the price stability versus full employment, you know, and these dual mandates that not every Fed member, you know, agrees on what position should be taken.
So, we have a bit of, you know, conflict within the FOMC. But also, too, the data has been quite mixed. I mean, we know that, you know, third quarter GDP, a lot of FedNow data is going to be, you know, in the high threes.
We've had some ISM that's been positive. We've seen a little bit increase in terms of prices paid on the inflation front. So, one of the issues heading into the fourth quarter, which normally occurs even without all of these other performance variables that are new to this year, you have this balance sheet window dressing, right?
That happens every fourth quarter. People take their profits. They kind of, like, want to go close to the vest.
They, you know, the year is, they want to lock in, you know, a good year that they should have had within fixed income given the incredible performance. So, we expect volatility in the fourth quarter. We look at that more as an opportunity, not a deterrent.
So, we stay with higher quality. Carry is the key, but look for increased vol with all of these uncertainties heading into the next month and a half. So, Leslie, if we take a step back overall as we're speaking here in November, what are your reflections on fixed income performance in 2025?
Yeah, I mean, look, it's, you know, it's amazing because we always consider, oh, how tight credit spreads are, how tight credits are. And you know what? They are.
But, you know, when we look at the change of where we sit today in, say, IG spreads versus where we started the year, okay, it's about the exact same, literally the exact same. I started the year at 82 basis points. If we look at the index today, I am 82 basis points.
High yield is only eight basis points wider than where it started the year. So, when you think, whenever it says credit spreads are so tight, and we do agree that they are on the tighter side, if you look at a long-term average, they've been that way for quite, for, since we started. So, what, the point being is that most of the returns in fixed income has been due to the decline in treasury yields that we've seen, right, from the beginning of the year, 40 basis points or so.
But more importantly, the most important driver has been income, locking in yield, compounding. That has really been the driver. And the performance of fixed income overall in 2025 has been, in my opinion, very good.
I mean, agency MBS are the best we've seen in several years. Even those sectors that have what we consider lagged, right, we would say have been lagged, are still, on a return basis, you know, very positive. Those that have reached a bit of, you know, headwinds in terms of supply dynamics or uncertainty, there's been, you know, even with those sectors, you're still 4%.
And what I'm referring to in this case is like muni. So, you've actually outperformed cash, which is what we anticipated. And we think that's going to be the same trend going into 2026.
But the performance of fixed income has been very good. But it hasn't been by, oh, wow, these spreads have compressed such a, by large magnitudes. From April, yes, they have.
Year to date, very little change. And that's why this has been really about some price appreciation, but more importantly, compounding income. Letty, to welcome you into the conversation, within this month's fixed income strategist report, it in part examines the outperformance of higher quality bonds in high yield throughout the course of 2025.
So, can you speak a bit to the key factors behind performance? Yeah, absolutely. Thank you, Dan.
So, I want to start off, first, the overall, discuss the high performance that we've seen within high yield, and then I'll go under the hood, like what's been causing higher quality to outperform, you know, the lower quality within high yield. So, the key factors for this year, you know, high yield has returned over 7% for a couple of years to date, 7.2. And we've seen that with rates coming down this year, that's really helped, the drop in rates has helped high yield as well, as with the Fed cut, and also the anticipation that the Fed will continue cutting is very positive, as for the issuers, this is reducing their refinancing risk, as well as lowering their interest expense.
So, that's going to be lower interest expense, higher earnings, a win-win for them. Also, high yield has been fundamentally stronger. If you look at the index, it's double B's right now are at 53% of the index, versus in 07, it was only 35%.
So, the overall quality of high yield is better, and we've had low default rates down to at 1.1%. We've had stable leverage at 4.4 times the 10-year average. And within the pandemic, a lot of the issuers financed their debt and lowered their debt, so now it's a much healthier balance sheet that high yield issuers have.
And lastly, I would say it's strong issuance. We've had over $290 billion of issuance, which is very supportive for the asset class. We've had loose financial conditions, but capital markets have been very welcoming to issuers to have new debt, and this past September was the third largest issuance on record with $58 billion of issuance.
And if you look even deeper, it's mostly been double B and single B that have been issuing. There's only 10% of triple C that have been issuing, and that's because most of those issuers have been going to private credit for new deals. Now, let's look under the hood.
Double B this year is up close to 7.7%, but single B is 6.7%, and triple C is lower at 6.3. How come? So, we've seen, like Leslie mentioned, trends haven't really budged much from the beginning of the year to the end of the year, except for triple C.
Triple C started at 7.46, and they've widened to 888, so that's 142 basis points that they've widened. Also, investors, when they're looking within high yield, they prefer to go into higher quality, so we've seen prices in double Bs come up. And then to go down to the sector level, these three sectors I'm going to mention did well in all three categories.
So, you had financials did well. We had telecommunications up close to 10%. They did well, and healthcare all outperformed the index.
The ones that had weaker performance in B and triple C was energy. Energy for double Bs was up close to 7.8%, but it was only 4.5% for single B, and for triple Cs, it was 1.5%. And then we had building materials and chemicals.
If you look at double Bs, they were up 7%, but for single P, it was 3%, and for triple Cs, it was only 54 basis points. So, overall, high quality for all those sectors I just mentioned, they really did much better than the lower quality. Well, thank you, Leti, for hitting on those performance drivers.
So, before we close out, as far as putting money to work in fixed income, Leslie, looking at positioning more broadly, what does CIO currently recommend for fixed income investors? Yeah, I mean, first off, our view is that overall fixed income will outperform cash this next year. First of all, because of the Fed cutting a couple more times, you're going to have that reinvestment risk.
But more importantly, our view is these are non-recessionary cuts, and that's the key. Our expectation is that, yes, you're going to see some clouded data, maybe even some slowing growth for the next couple of months as we digest this lag as maybe the labor market remains cool, doesn't crack, just remains cool. But overall, our expectation that you're going to have all this fiscal stimulus that we've seen and the productivity that we expect through AI will really accelerate growth in the second half of 2026.
So, we do believe that fixed income outperforms cash. So, we have to be very attuned to the risk that we're taking, and we still want to go into that high quality sectors because the carry there remains good heading into 2026. We also look at portfolio correlations, and we are leaning more towards at this stage more what we call the securitized product over corporate credit.
As they reach or near their 75, 77 basis points, their 25-year tightened spread, we started to shift our allocation more towards securitized. Agency MBS, for example, that the current coupon is yielding a 510 higher than what is in BIG. That is an asset class that doesn't have credit risk, and that's a lot of liquidity.
So, those kinds of shifts that we've made to try and pick up that incremental total return into 2026, we think will benefit wealth. With that said, even though we're neutral on the higher credit embedded sectors, we don't deny the carry that's there. They're very good carry.
You can have very good compounding income. So, we're not saying that you shouldn't hold them. So, high quality, we stay around the three to five-year area of the yield curve.
We have high quality and securitized, good compounding income, and that'll really be the core of what we see into 2026. Well, Leslie and Leti, thank you both again for dropping by Top of the Morning to keep our listeners, our clients informed on CIOs thinking when it comes to fixed income and positioning within the asset class. Great catching up with you both today.
Thanks, Dan. Thanks, Leti. Again, today we have been joined by Leslie Falconeo, Head of Taxable Fixed Income Strategy, as well as Leti Zimides, Fixed Income Strategist, joining us from the UBS Chief Investment Office.
The publication which we have been referencing throughout our conversation today, that being for the month of November, the Fixed Income Strategist Report, title is Reaching for Yield, is now available for you up on ubs.com forward slash CIO. For clients of UBS, please reach out to your UBS financial advisor. If you would like to receive a copy of the report directly from UBS Studios, I'm Dan Cassidy.
Thank you for joining us. UBS Chief Investment Office's investment views are prepared and published by the Global Wealth Management Business of UBS AG or its affiliate, UBS. This material has no regard to the specific investment objectives, financial situation, or particular needs of any specific recipient and is published for informational purposes only.
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