Top of the Morning: Fixed Income Strategist - The Lending Powering AI Investment

Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.

For today, we will revisit fixed income markets as we will highlight the latest fixed income strategist report from the UBS Chief Investment Office, the Lending Powering AI Investment. Joining me here for today's conversation, glad to welcome back from the Chief Investment Office, Leslie Falconeo, Head of Taxable Fixed Income Strategy for the Americas, as well as Barry McElindan, a Senior Fixed Income Strategist for the Americas. So with that, Leslie, Barry, before we begin, I want to thank you both for dropping by and for spending some time today with our listeners.

Great to be with you both. Thank you. Thank you, Dan.

So before we get to that feature article, again, focusing on the Lending Powering AI Investment, Leslie wants to begin with a fixed income market update. Now, since we last spoke, U.S. interest rates have undergone a pronounced repricing. So what factors have driven this movement?

Yeah, I mean, you know, it's incredible when you think about it, Dan, because when we, every day there's this, you know, different rhetoric in terms of how long this, you know, ceasefire is actually going to last. And unfortunately, the market is at the whim of that dialogue until there's actually something signed. So, I mean, some of the factors that we're seeing in terms of the rise in rates, you know, first off, the economy is, you know, is incredibly resilient, right?

We know that retail sales, ISM, you know, the recent payroll numbers have all been, you know, strong. And I think they surprise to the upside. We also know, as expected, that inflation is still lingering, as we see from that CPI report.

But the question is whether or not it has actually peaked. So while all of those have been drivers, the main driver of why interest rates, particularly that tenure, was rising is because the market is repricing the Fed path. And while in March, when the initial conflict started, they might have taken out the cuts that were at the end of February.

They had yet to become real. The markets really wasn't that hawkish where they were pricing in actual hikes. Over time, and as the longer period of time the ceasefire exists, the more hikes the market starts to price in.

So we went from saying, okay, you're not going to cut high for longer, right? The market sort of flattened out a bit, if you will. And then it said, you're going to hike.

And then after this, you know, past couple of weeks, it was solidly saying, you're going to hike. But now they moved that hike into December 2026. Now, these, you know, you know, averages, if you will, and these expectations can vary.

They always do. The more fixed income market is forward-looking. It has a tendency to speculate, you know.

But, you know, what it's going to come down to truly is a show-me market. So right now, it still has a high probability, right? The market still went from 100% in December 2026 now to say, like, 75 of a hike, and another hike around March of 27.

But again, this really is, it moves around quite a bit, but there's no question, it's changed to a hawkish tone. And that tone, outside of the stronger economic data and stronger fundamentals, push that 10-year higher. Leslie, as we're speaking today on Friday, June 12, we do have a Fed meeting coming up.

Can you speak a bit to CIO's current outlook for monetary policy through the balance of 2026? Yeah, I mean, we, after the CTI reported, this was always something that, you know, was being re-evaluated as information came in. And there's such, you know, still uncertainty, if you will.

I mean, I've never, you know, had two words, resilience and uncertainty, these two words spoken in the same sentence so many times, because you look at the economy and the consumer, you say, well, it's much more resilient than one would anticipate. But the uncertainty comes from what the path is going to be going forward, not just in terms of growth, but also how long that higher inflation might actually last for. So after, you know, re-evaluation, the CTI number came out, our economics team had decided to go for the high for longer type approach, you know, with the expectation that while the cut would probably happen in, say, March of 2027, and that's really, Dan, the big difference is, while the market is saying, you know, the Fed's going to hike, we're keeping the view that, no, the next move is going to be a cut.

We're just pushing it out, right? Because after, when we have such a prolonged ceasefire, that data and that inflation data, you need to really give it some time to pass through. You need to give it some time to make sure that, you know, it's on a downward path, even though we know it's going to remain well above the Fed target of 2%, which it has for the past five years.

But the FOMC is just going to need a bit more period of time before they actually begin to move. But we'd still say that the next move is not a hike, the next move is a cut. And although we are expecting above-trend growth, you know, we might see slower growth in the second half, and we do expect inflation to come down, but it's just going to take a longer period of time than we first anticipated.

Leslie, in terms of positioning within this month's fixed income strategist, a couple of changes were made to CIO's positioning preferences within the asset class. Can you walk our listeners through these changes? Yeah, absolutely.

I mean, the word resilient is not just used for fundamentals in the consumer and the economy, it's also used for spread product. I mean, the change in spreads that we've seen, whether it's a corporate credit or securitized product, has been very, very consolidated. You haven't seen big moves in change in spreads, even though we've had bouts of volatility throughout the year.

And if we look, say, at change year-to-date, it's, you know, maybe a handful, maybe tighter or wider, mostly are tighter than what we saw entering the year. So that's, you know, in 2025, spread product did really well. So it's continuing that momentum into 2026.

So when we say, like, you know, our value, where we see relative value, if we remain in that high quality, we are well aware that the future, that the projected total return is going to come from the yield and not the spread. And why we say that is that, you know, the corporate market, you know, maybe one or two basis points wider now, had gotten to levels that we hadn't seen in, like, you know, 25 years, down to 73, 74 basis points. Maybe their basis points are too wider now.

Even the high yield market, you know, at 275, 280, are very, very tight. So, you know, these spread levels continue to be compressed, but we don't see any reason in the near term why we should have, you know, a gap wider, right? Because, again, we're putting a very low probability on a recession, even though slower growth might happen in the second half.

We don't think there's going to be a recession. The equity market, while we have, you know, a bit of hiccups here and there as a dialogue in terms of the ceasefire continues, you know, we still like the equity market. So, but most of the, you know, total return performance driver is going to come from yield.

And those yields that people are earning are, you know, are the highest we've seen in the past 10 years. Now, granted, the majority of those yields are from the level of interest rates, right? Because treasury yields are higher.

It's not from risk premium. It's from the level of rates. But we think that that's going to be enough to really serve as a very strong cushion going forward to have these total returns.

So, what we have done is that we've been in the high quality for quite some time. We continue with that path. But one of the changes that we did make was as the 10-year, you know, had moved up to around that 460 level, you know, we were what I call long that short end, right?

At 4.5%, we went to that short end of the U.S. Treasury, right? Because the market was pricing in hikes, we felt it had gone too far.

And then when we moved higher from that 450 level around 460, we actually, what we call expanded interest rate risk out just a little bit, right? We went more towards that five, six-year part of the curve, still mainly in the short end, but just taking advantage of those higher yields. And what we did is we added to taxable munis.

You know, municipals has been an attractive on our preference since April. And we added to the taxable munis side because that was a sector that had really experienced some headwinds this year. And one of the few sectors that was actually showing a negative total return because of a little bit of spread widening, because the impact of interest rates.

So, and because our view is also that the 10-year Treasury ends at about 4.25 at the end of the year, we took that opportunity to stay in high quality, diversify our high quality basket, and to add some taxable munis. Leslie, very helpful to hear about CIO's current positioning views across fixed income and hearing about that assessment of the rate environment earlier in the conversation. Now, I do want to welcome in Barry McElinden to talk a bit about the feature article within this month's Fixed Income Strategist, because it shines light on the lending that is powering AI investment.

So, with that, Barry, welcome to the conversation. What has been taking place here, and what would you say are the implications of this all to credit markets? Thanks, Dan.

I mean, what's been taking place, we're seeing that AI, lending for AI investment has been utilized through all different fixed income sectors. So, traditional bonds in the investment grade corporate market, mainly issued by four hyperscalers, but new structures that have emerged in terms of project financing, deal structures, but they take the form of a bond type of instrument, both rated investment grade as well as high yield. Also, the traditional asset-backed and commercial-backed securitized segments have been utilized for funding, as well as the senior loan or leveraged loan market.

So, really tapping all of the different fixed income segments. And, in addition, we've seen some equity raises being announced in various forms as well, common stock and convertible securities. So, I think we've established a clear blueprint.

We knew headed into the year, we thought that all of these different types of avenues in terms of raising funds for the massive build-out would occur. And I think we really have more clarity at this point as we approach the first half, finishing the first half of the year, what exactly the specific structures will look like. So, let me just kind of go through, first, in terms of just a regular senior unsecured bond market, you've probably seen, listeners have seen a lot of headlines about big hyperscalers with large debt raises.

And that's true. In the U.S. dollar market, they've raised about $107 billion. There's a trillion of gross issuance in investment corporates year to date.

So, it's only about 10% of the market though. So, it's not like it's the majority of the market. In fact, the big six largest U.S. banks have actually had larger gross issuance of about $120 billion year to date than the four hyperscalers in terms of U.S. dollars.

So, in no way would we say it's flooding the market, but certainly it's a lot larger than it has been over the last few years, where they've only issued about $15 to $20 billion annually just a few years ago. And then, in terms of their regular bonds, another bit of a surprise to the market was how much they're utilizing currencies outside the U.S. So, corporate bond markets that exist in Europe, Switzerland, U.K., Japan, and Canada, they're utilizing bonds issued in those respective currencies as part of their overall funding profile.

In fact, a third of the four hyperscalers they've issued debt this year, a third of it has come in the form of non-U.S. currency bond issues. So, that's something that, again, the market expected, maybe not so on a global basis, but putting it into perspective, you are growing the sector within tech and hyperscalers, but it's still slightly less than 10% on the aggregate of the full index. Whereas, think about banks, U.S. banks, close to 20% in terms of index weighting.

So, it definitely has still scope to rise as far as how the markets are segmented today. Then, some of these other structures that I mentioned, like the project financing deals, so these are types of structures that have been formed in the marketplace to help fund data center build-outs. They are a small part of the overall funding mix, though.

Total is about $50 billion year-to-date, roughly about $20 billion that had investment-grade ratings, and $30 billion in high yield. So, again, a small sliver of the overall funding mix. They are a bigger portion of the high-yield bond market because that's a smaller market, but still, they come in the form of private offerings in many cases, so 144A bond issues, not necessarily open to the general public, but more of an institutional investor base.

They're definitely nuanced in terms of how they are structured. There's some unique risk factors to take into consideration, like construction risk of the data center, who is the ultimate tenant on the hook for the cash flows, and how does that lease term compare to the lease term of the security that's being issued. It doesn't require quite a bit of specific structural analysis, but again, I think the fact that all of these terms are pretty transparent to the investor base, which is largely, again, more of an institutional investor base, I don't foresee this really being a problem to the marketplace.

It's just something that the investors will have to take time to feel comfortable with the risks involved, and also, are they being compensated in terms of credit spread, because they do trade at a wider spread than you would see for the hyperscalers regular bond. So, that's been quite a unique development that we've seen, and I think these trends, as mentioned, will continue. So, just making sure that these funding channels remain open, obviously, is going to be important going forward for the massive build-out that's required for the various different types of AI engagement going forward.

But overall, I think about fundamentals within the sector. If I just focus on the largest hyperscalers, we do also find that they have ample capacity on their balance sheets to be able to increase their leverage, and in many cases, their leverage in terms of just debt to EBITDA, so that's the traditional growth leverage metric, it's less than one. The hyperscalers still have really ample cash on their balance sheets, and they really haven't drawn down those cash balances, which might actually be surprising for some listeners to hear, but they've pretty much kept or actually even grown their cash balances.

So, they're not depleting their cash, but they still have that as a buffer, which helps to strengthen just their overall credit metrics. So, yeah, we think that the trajectory of leverage is higher, but there's so much buffer in place for the large hyperscalers that there's room for them to continue to issue these bond deals, especially relative to the growth that we've seen coming out of the latest earnings quarter in terms of their future revenue and cash flow from operation projections. So, we think that the situation with fundamentals is relatively benign, but, yeah, so, overall, I think this is kind of a major topic for fixed income and certainly the credit markets, something that certainly is getting a lot of headlines today, and I think when you take a step back and just think about the size of the issuance that's taking place relative to these respective fixed income sectors, there's still just kind of a smaller portion, so there's definitely room for these sectors to absorb a greater degree of issuance over upcoming quarters that we expect to occur.

Yeah, Barry, some very interesting developments. Thank you for sharing with our listeners, and we will continue to monitor this as, of course, AI and the infrastructure that supports it remain in focus, but with that, Barry McElindan, Leslie Falconeo, a great speaking with you both. Thank you again for dropping by Top of the Morning on this Friday to provide our listeners, our clients, with thoughts on the fixed income environment and positioning within, and look forward to picking back up with our conversation at some point soon.

Thank you, Dan. Have a great weekend. Visit ubs.com to view the latest research. and brokerage services are separate and distinct, differ in material ways, and are governed by different laws and separate arrangements.

In the USA, UBS Financial Services, Inc. is a subsidiary of UBS AG and a member of FINRA SIPC. For information, please visit our website at ubs.com forward slash working with us. For a full legal disclaimer applicable to the independent investment views produced by UBS, please visit our website at ubs.com forward slash CIO dash disclaimer.