Top of the Morning: Fixed Income Strategist - Optics and opportunities

Leslie Falconio · UBS Chief Investment Office

Credit spread widening from very tight levels is normalization and an opportunity, not a red flag.

Spreads on investment grade and high yield had been very tight most of the year, so the widening is a return toward normal. Falconio says higher real yields and volatility, and tighter financial conditions from higher borrowing costs, drive it. She does not see the widening as a catalyst for a downturn. Household and corporate balance sheets are healthy, so fundamentals are intact. Dispersion across credits is a theme, so investors need to be selective. The widening may continue for a while as volatility stays elevated.

“But we don't look at these widening spreads as some sort of catalyst going forward. If anything, we view it in more of an opportunistic fashion because again, these balance sheets, both household and corporate balance sheets are in healthy positions.”at 7:09

Leslie Falconio · UBS Chief Investment Office

Agency MBS is attractive; rate volatility hurt it, but the same spike is unlikely to repeat.

Agency MBS was one of 2025's top-performing sectors. Its September underperformance, the worst monthly result since 2022, came from a sharp rise in rates and volatility: about 30 basis points in 10-year yields within a week and a half. Spreads widened, and mortgage rates rose above 7.5%. Falconio notes that over 53% of mortgages are locked near 4%, and that MBS convexity has improved a lot since COVID, so negative convexity bites less. She does not expect a move of the same magnitude again. She calls the sector a great diversifier with high quality and good liquidity.

“We've kept our attractive. We don't think that, you know, you're gonna see that spike with that same magnitude going forward... We think it's a great diversifier. We like the high quality. We like the liquidity.”at 10:00

Leslie Falconio · UBS Chief Investment Office

UBS keeps carry exposure to preferreds and high yield despite spread widening.

UBS holds some lower-credit-quality exposure, mainly preferreds and high yield, for carry. Falconio notes $25 preferreds had some of their worst yearly returns in decades, if not ever, and that high yield has widened recently. She says UBS is keeping those positions because the income still gives a cushion against spread widening. She does not expect a catalyst in the economy that would make those spreads blow out.

“We do have some what we consider lower credit quality, whether it's $25 preferreds that have had some of their worst yearly returns in decades, if not ever... And some of the high yield that we had added on with spreads starting to widen out, we're keep those positionings on.”at 12:06

Leslie Falconio · UBS Chief Investment Office

Municipal bonds are a buy-and-hold opportunity given attractive tax-equivalent yields.

Falconio says UBS thinks yields are cheap, so long-end municipal bonds are attractive for buy-and-hold investors. Tax-equivalent yields make the case, given the high yield level. This is a recommendation tied to the yield level and tax equivalence, not a bet on a near-term move.

“We think yields are are cheap. So if you're a buy and hold investor going into, you know, long and munis right now, given those tax equivalent yields is a great opportunity.”at 12:46

Leslie Falconio · UBS Chief Investment Office

Adding interest-rate risk in the 5-7 year Treasury part of the curve as yields rise, not chasing rallies.

UBS added interest-rate risk as yields rose, moving some exposure from short-end Treasuries into the intermediate 5-7 year part of the curve. Falconio admits they added a little too early, around the 5% level, and took paper losses for a couple of weeks. She still argues dollar-cost averaging into rate risk is prudent. The reasoning: yields moved up too fast to be sustainable, and the market already prices a hawkish outlook. UBS stays slightly cautious on the back end tactically because of volatility.

“We still think it's a good idea and prudent to start sort of average costing and and adding on to that interest rate risk. You don't necessarily chase rallies, but what we do is that we wanna add to interest rate risk as these rates rise.”at 4:48

Leslie Falconio · UBS Chief Investment Office

Treasury yields rose too fast to be sustainable and should trend lower into year-end, with volatility along the way.

Q3 saw 10- and 30-year yields jump to their highest since 2002 within weeks, driven by real yields and rate-path repricing. Falconio argues the pace, not the level, is the problem: moves that fast are not sustainable. She also notes the market already prices a hawkish Fed, and that yields have been falling even though some inflation prints have not abated. She expects yields to trend lower into year-end, but says the path will not be a straight line and that the move down is not an all-clear. Over the next six months she looks for the 10-year to go below 5%, roughly 4.5% to 5%, for 2027.

“And and we do look for yields to trend lower into year end.”at 5:33

Leslie Falconio · UBS Chief Investment Office

Treasury yields are multi-decade cheap, and high starting income gives a cushion against moves.

Falconio says yields are at multi-decade highs, not since 2002, so investors should not treat them as cheap relative to 2025. She argues this gives a large cushion. Income compounding is a driver of total returns, so investors should not worry about every 25 or 30 basis point move in yields. The point ties to her view that yields are cheap and that the income cushion protects returns through volatility.

“We're talking about multi decade cheap highs in yield. So I really don't discount the amount of cushion that you have from this compounding income that we feel will be a driver of returns.”at 11:08

Leslie Falconio · UBS Chief Investment Office

Market prices a more hawkish Fed than UBS expects; UBS sees a December hike, not the market's full path.

Falconio says the market is pricing in a more hawkish Fed path than UBS. The market expects about three more hikes through 2027, while UBS was looking for about two, with a possible start to cuts in late 2027. She says the Fed will probably hike two more times, but that this adds up to about 75 basis points of hikes, a return of some of the 2025 cuts, and is not a huge headwind to risk assets. She expects a Fed hike in December, which she says the market is already pricing in.

“the market is pricing in, in our opinion, a more hawkish Fed path than we are.”at 2:11

Leslie Falconio · UBS Chief Investment Office

Supply-driven inflation concerns will fade; the real question is how long it takes to reach 2%.

UBS believes supply-driven inflation concerns will fade. Falconio argues the Q3 bond selloff was less about inflation rising and more about how long inflation takes to return to the 2% target. Breakeven inflation expectations did not skyrocket during the quarter, which supports her view that the market worries about the timing of the return to target, not an inflation spike.

“It's not just about whether the supply driven inflation concerns are going to fade, which we do believe they will, but it came more about reaching that 2% target.”at 3:00

Leslie Falconio · UBS Chief Investment Office

The economy stays on solid footing, with growth slowing in coming months but not turning into a downturn.

Falconio says Q2 growth was solid and Q3 expectations also show growth on solid footing. The rise in real yields reflects that strength. She expects growth to slow in the months ahead, but not into a downturn: the path is not a straight line. She points to the absence of a catalyst in the economy, which means spread widening and volatility should not turn into a broader credit problem.

“But overall, we do think that the economy stays on solid footing. We do have, you know, growth slowing in the months ahead, but, you know, at least a trend.”at 11:41

Leslie Falconio · UBS Chief Investment Office

Rates volatility will likely last about six months given Middle East, Fed, midterm and supply uncertainty.

Volatility spiked in Q3. Falconio expects it to continue because of several unknowns: the Middle East conflict and how long it runs, uncertainty over Fed action, the midterm elections, and supply. She expects volatility to last about six months, so investors should not chase markets and should wait for better entry points. She says the portfolio is diversified and positioned for this.

“But again, we do think volatility is gonna last, you know, for the next six months or so just given all of this uncertainty that we have.”at 12:57