Fixed Income Conversation Corner with Ken Shinoda (DoubleLine) & Leslie Falconio (UBS CIO)
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This conversation was recorded on January 10th, 2025. Hi everyone, Dan Cassidy here. Welcome back to the UBS Market Moves podcast channel. We are back today with the Fixed Income Conversation Corner podcast series, our first episode of 2025. With that, we are joined today by Leslie Falconeo, head of taxable fixed income strategy for the Americas with the UBS Chief Investment Office.

Excited to welcome back to the conversation Ken Shinoda of DoubleLine Capital. Ken serves as Portfolio Manager for non-agency RMBS. So with that, Leslie, Ken, thank you both for spending some time today with our listeners, our clients. Leslie, I'll pass it over to you to lead today's conversation with Ken. Thank you, Dan. And, you know, thank you, Ken, so much. I really appreciate you coming on. And this is today is just a great day to have you on.

you know, on this podcast. And I know that our, you know, advisors and clients are going to be really tuned in as to some of your thoughts in just terms of the markets and some of your sector preferences. And I know a lot of things that you're thinking about really coincide in our view as well. So I really appreciate you, you know, taking the time on this Friday payroll number to, you know, speak with us. Thanks for having me. I appreciate it. And, yes, it's an interesting day with the rates falling off here.

Absolutely. So why don't we just like, why don't we just, that's a great sort of segue. So let's talk about this. I mean, you know, we all know and we've all, everyone has, you know, discussed even prior to this payroll report how much, you know, interest rates have gone higher since the Fed cut 50 in September. And we have obviously a lot of shifting sentiment going on. But, you know, when we think about, you know, interest rates at these levels, right? I mean, today's payroll report at

You know, 256, the highest in smarts in 2024. It's, you know, the 40-something consecutive positive that we've seen. And obviously, we don't have, you know, slowing growth in the near term. What are your thoughts in terms of where yields are now and how investors can play really compounding that income and their demand for these yields? All right.

I think we've gotten much more closer to fair value. It's been a pretty schizophrenic market. I mean, just looking back across 2024, the tenure started at 380. It sold off over 100 basis points.

to roughly 100 basis points to about 470. We've had a huge rally down to 360, another sell-off back up to about 450. So the market continues to go through these schizophrenic waves of the rate cuts are coming to higher for longer. And so we're back to a little bit more of that higher for longer mantra, just even from yesterday until today, if you looked at

the world interest rate probability function on Bloomberg, there was an estimate of roughly two cuts this year, which is now down to basically a little more than one cut this year. So what's really happening is the market is trying to figure out what the new terminal rate is going to be for Fed funds. And then the yield curve is showing some signs of yield premium, return premium as you go out the curve.

And we've normalized a lot. So right now, the market's kind of saying by the end of the year, we'll be around 4% on Fed funds, two years a little bit above that. And now you have some steepness in the curve. So I think there's a chance maybe the 10-year wants to retest that 5%.

The long bond, the high was in 23 at 511, roughly. We're almost there. So if you've been thinking about nibbling on some duration here, it doesn't really seem like that bad of a time. If you go back post-GFC, we've had a couple bouts of these big rate sell-offs.

This is some work done by a rates technical analyst at J.P. Morgan I was reading the other morning. More often than not, they last about three to four months and the rate sell-off is about 100 basis points. That's kind of where we are today. The only outlier was 2022, which

which was when we were doing those back-to-back 75 basis point rate cuts. So based on at least the last roughly 15 years, this magnitude of a rate move with this timing, roughly three to four months, has typically been a decent time for the market to kind of slow down its pace of

of price drops or yield rises. So I think it's a decent time. Obviously, it could go higher, but you're supposed to buy when it feels bad like this, right? Absolutely. And I think to your point as well, and we feel the same way. I mean, we've been a little cautious on that long end. We stayed really using our compounding income that carry, preferably in the short end. But to your point, now that the Fed –

you know, and now the market, I should say, only, as I said, doing one cut this year, you know, at the end of the year, around the September, October time, you know, and it's,

Our particular view that, say, you know, a hike is we never want to say never, but highly unlikely unless you see a huge reacceleration of inflation, you know, outside of just consistent sticky inflation. What's your sort of view in terms of what you think the Fed does this year in terms of, you know, your call of what they what they could do or what they should do?

I think it's, as they tell us, they're very data dependent. So obviously today the market is very data dependent because the Fed tells us they're very data dependent. So this jobs report coming in strong is refreshing the market. But it's the last couple of data prints, everything has kind of been bad for bonds. So you get to the point where all this negative bond activity

that comes through, whether it's surprise upside on prices prayed, which was what caused the last move up, today's payroll number. You get to a point where it's all kind of priced in. And so now you get that protection when you buy bonds for the surprise of the other way.

The Fed had kind of moved off its focus on inflation towards the end of last year, really focusing on what they thought was going to be weaker, weakest in the labor market. Then they got towards the end of the year, stronger economic growth, some inflation being sticky, moving kind of sideways. So now they're they're back to kind of looking at both those things, I think. And yeah.

they're just gonna have to wait for the data. So you're gonna see, I think, a pretty schizophrenic market based on how some of this high frequency data comes in.

But if you look at the underlying numbers we got earlier this week with the job openings, while job openings were up, the quits rate was down, the hiring rate was down. So that implies that, you know, the people or the companies, while they're not laying people off, they're just not hiring as aggressively. And so it's harder for people to quit their job and find something new. So I think that takes a lot of the pressure off wages and

And so I think that will help inflation continue to slowly move its way down, which could allow the Fed to perhaps move more aggressively than just 25 basis points through that. Yeah. A lot of time between now and then.

Yeah, I think that's an incredibly important point. I mean, I think one of the things that, you know, you and I have both seen in just the years in this market and particularly heightened, you know, the past several years is that this debt-independent Fed, you know, it has caused a lot of volatility in the marketplace. And obviously, you know, we're only sitting at January 10th.

and while this you can't deny this number strong i think your point is that it is a really important one is that ok there's not a lot of layup going on no question but there's not a lot of hiring going on the and i do think that this to your point this is one number we were looking for two cuts this year

This is where we stand. And it could change as the data comes through. But I do think the important part is the market is, in our opinion, I think as you're stating as well, with the outlook on the Fed, become a little bit on the hawker side. So let's look. So when we think about the fixed income side, and we are long things like agency MBS, we like Securitize, but fixed income –

as a whole, you know, akin to the equity market, you know, is, has seen a lot of spread compression, right? We've, we came into the year, you know, we're, we're fairly tight here. I mean, everything's relative, but you know, we're at a tight level. But one thing that we do know, and we feel given the fact we have an upward sloping yield curve is that cash is not as attractive starting in 25 as it was starting in 24. Like, what are your views sort of on, you know, you know,

fixed income spread product and people, you know, you know, keeping that cash and carry for 2025. I think you bring up a great point on the, the shape of the yield curve. Now you've got some positive slope. I'm looking at three month bills and the low fours, 430 right now, probably headed to four. And with the backup and rates and the now having some steepness instead of inversion, you know, there's a,

There can be a significant yield advantage and total return play kind of going out the curve a little bit. And I'm with you. I don't really love the ultra-long end, so I'm not suggesting people go buy the long bond. We're actually underweight, the long end, in most of our strategies that can use futures. We've had a 230 steeper on, which has worked pretty well.

over the last couple quarters. But, you know, think about if you build a diversified portfolio of high-quality credit at the front end of the curve, you can pick up about 100 basis points over, let's say, the two years. So you're talking about five-and-a-half-ish type yield, five-and-a-quarter, five-and-a-half-ish type yield. You're picking up over 100 basis points over T-bills. You're locking it in for a year or two if you want to play safe and not have

too much risk, that's one way you could do it in kind of low-duration type products. And if you build a diversified credit portfolio that's, you know, BBB to BBB in a mix of credit, including things like higher end of the high-yield bond market, not CCCs, but BBBs and, you know, better single B companies, some bank loans, some secure cash credit, you can get now a yield almost 7%.

And I think that credit in an environment where inflation break-evens remain subdued at these yields, given how big the run-up has been in equities and valuations, there's a chance for that credit to outperform, I think, equities this year. And it's starting off pretty good, looking at where equities have gone and how high-yield spreads and credit spreads have behaved.

Yeah, I completely agree with that. And I want to ask you, too, when we think about, say, let's just go to sort of the housing mortgage kind of environment right now, and it's either agency or non-agency. But let's – we would be – let's not talk about the fact we have a new, obviously –

know, President coming into play, and I'm sure you saw the headlines last week in terms of taking off the conservatorship in terms of these Fannys and Freddys, and we had the preferreds on Fanny Freddy like Skyrocket. How do you think sort of when we look at the next couple years, like the Trump administration will impact, you know,

You know, whether it's the agencies or housing or how do you feel that it could sort of, you know, transpire over the next year or so, if it has any impact at all or if it's just completely jargon?

Yeah, there's a debate about this. I just don't think it's going to be ultra high up on their list of to-do things. It sounds nice to privatize, but I think that would raise the cost of capital. So mortgage rates are really high. I think the last thing that...

him and his administration wants to do is increase the cost of capital for homeowners. It's not really politically expedient. So it sounds nice to take Fannie Freddie public again, but it's highly likely that would actually push mortgage rates higher and spreads wider. So I think if you've listened to him recently, he's talked about how interest rates are too high. So this

This would actually take rates higher. So I just don't think it's going to be too high up on their list of to-do things. I think it's possible to take them either out of conservatorship and to be private companies or bring them out as public companies, but that probably takes the cost of capital higher. It wouldn't be a good thing for the Americans and homeowners to have that happen.

Yeah, I mean, I happen to agree with everything that's happened. I know it's been, you know, we've had a lot of client questions about it. We've sort of had this playbook before, you know, during 2016, and we don't ever want to say ever. We completely agree that, you know, we have midterms in two years, and he's going to try and get done things that he is really on top of his agenda, and this is

not one of them, obviously. And I completely agree with you about the potential negative impact that might have to mortgage rates and the homeowners. And, you know, the affordability issues that we're seeing has nothing to do with, you know, privatization of the agencies. So I, you know, with that, I just, I do want to sort of shift here kind of just how are you looking at,

sort of like the relative value between, say, mortgage credit versus what we've seen in corporate credit, and what kind of opportunities and vulnerabilities do you see between the two right now, given a sector overall in fixed income that's not overall cheap, but there is relative value between sectors right now? How are you looking at that?

Yeah, look, corporate credit has had a phenomenal run. It's done really well. We wish we owned more. We own some in our kind of diversified products and core plus products. But it's now you got investment grade spreads. They're a little bit wider today with the rate off, rate sell off. But they actually got to the tightest levels since the global financial crisis. High yield as well. Yeah.

has had a great run so when we look at high quality fixed funds there's definitely a spread pickup to buy both agency mortgages and securitized credits securitized credits things like non-government guaranteed residential commercial mortgage-backed securities asset-backed securities and CLOs I think there's more room for spread tightening and just to kind of put things into perspective short corporates are probably when I say short maybe like one to three year corporates are probably

Sub-Treasury is plus 50 now, so 30 to 40 basis points versus a short securitized paper. You can still find paper that's like 100 to 120 basis points. So you can pick up 60 to 80 basis points-ish in the short end of the securitized markets. I think that difference is going to continue to compress.

And as you go kind of out the curve to the five-year portion, looking at things like BBBs, you can still buy BBB securitized paper that's in the low 200s versus if you're in the corporate world, that's probably closer to 100 over. So you're picking up 100, 150 basis points depending on the credit. And that relationship is very wide relative to history, and that's going to, I think, continue to tighten historically.

absent some 10-plus percent correction in the equity market or bond outflows, which I don't think we're going to see the same type of outflows that we saw because the Fed's not hiking anymore. They're going the other way.

Now, agency MBS is a little bit different of a beast. It does look cheap to corporates. It has done better up until very recently from an excess return standpoint. The challenge is that it's much more of a rates product. So you can have an environment with if rate volatility stays elevated, MBS spreads may not tighten and play catch up as much as the credit markets. There's just like a different buyer base. There's different technicals related to it.

But if you're looking for a hedge for that 10% plus correction in equities, credit is correlated. So if you see a correction in equities, it's highly likely that corporate credit spreads will widen. So IG will widen, high yield spreads will widen, and all the securitized credit products will widen as well. That sell-off is probably going to be, I think, it's

It's going to come with the bond rally in which MBS does well in. So within the fixed income universe, it truly, while it's underperformed everything because stocks have ripped and credit spreads have done well and rates have sold off, if the opposite happens, credit spreads widening, stocks coming down, that's really when agency MBS shines. We just haven't had that environment because...

Because it's been a one-way train risk on for quite some time and with rates selling off. So agency mortgages, think about it as a very defensive part of your portfolio. You want something that zigs when other things zag. And barbelling credit with equities, you're kind of long kind of the same trade. So that's how you should think about agency mortgages. The spreads are so wide relative to history. And I'm looking at a chart of the...

The yield on the index is about 530, which is not quite the highest it's been, but it got up to 6% in 2023. But in 22, we were kind of right at this level. We're close to the highs of 24. So this is some of the highest yields on mortgages that we've seen over the last five years.

And then put on top of that, just the tightening that you've seen in some of the other credit markets. It just seems like an interesting time to be adding some of that exposure in your portfolio. And it's not really long. It's kind of the belly of the curve. We're not talking about 30-year bonds. If you're active in the MBS space and we have a couple products on your platform, DBLTX and

And the new ETF, I was just looking at the ETF, it has about 100 basis. Both those products have about 100 basis point yield advantage relative to either the Bloomberg Aggregate Index or the Bloomberg MBS Index, 100 basis point yield advantage.

You know, and I think it's important. I think that was a great, you know, overview. And as I mentioned, we have what we call most attractive in agency MBS, too. You know, a lot of our clients sometimes go back to, you know, either GFC era or times when they think, you know, mortgages extend to the backup and contract during a rally. But, you know,

You know, how could you sort of, when we think about how people are locked in, the rate that they're locked in at is that a lot of that extension risk that people think about has been very mitigated. So what is the risk to, like, the agency on the S side right now? You think it's just a, what would it be? Would it be a positive correlation return with equity and fixed income that we get a 2022 scenario? Or do you think that a lot of the...

risks within MBS are mitigated for, well, number one, much better regulation after the GFC, and number two, people are locked in at a 3.8. How do you view that in terms of its relative value?

Yeah, so let's talk about, let's separate credit and agencies because the agencies, Fannie, Freddie, Jeannie Mae, they're government guaranteed. You don't need to worry about the credit. And during the global financial crisis, it actually was the best performing part of fixed income outside of treasuries. Treasuries and agency mortgages did well, spreads widened on everything else. Corporate spreads, I think, got to...

something like 600 on investment grade and 2000 on high yield for, for a brief moment. Um, seems like a long time ago now. So agencies, your risk is not credit. You're really thinking about prepayments. Um, will people refi if rates fall? Will people, uh,

prepay as rates rise. So you get this extension and rates rising and you get that prepayment risk and rates falling. It really depends what you own. If you buy the index, the index, while it has some of the new production mortgages with these 7% interest rates that are obviously going to

going to prepay really fast if rates fall. Most of the index is legacy loans originated over the last five years with those low coupons, three, three and a half, four. And those bonds backed by the low coupon mortgage loans are pricing in very, very slow prepayment speeds. So you have very little extension risk left in most of the index.

Your prepayment risk is really associated with these brand new loans. There's some of it in the index, and then as time passes, more of the index will become those high coupon loans. There's a big difference between buying an index fund and buying an actively managed fund because the active manager can kind of pick and choose where to play in these different coupon mortgage bonds. So prepayment risk is really high for brand new stuff and really, really low for the old loans.

of yesteryear. And if you have a manager that knows kind of where to go, you can create a portfolio that can do well in both rising and falling rates. But broadly speaking, if you just want to go out and buy the index, they're

the risk from a prepayment standpoint is close to the lowest in over the last decade, that negative convexity. When it comes to mortgage credit, and you noted it, it is not quite the safest it's ever been, because I would say the safest is right after the crisis happened, but

But mortgage origination quality is extremely high. You have to put money down 20%, 30%. The CFPB, which is the Consumer Protection Finance Bureau, highly regulates all these originators. So the process by which they originate and underwrite loans, think about collecting information about income and all that stuff, it's very strict.

So I actually think the credit risk is very low on these assets from default. You probably have more risk associated with natural disaster, in fact. And the sad things happening in LA are a prime example of that. But insurance will cover most of those losses.

So it's not really – we think on the mortgage credit side, it's less about credit loss risk. It's more about prepayments associated with those assets. So there's really not much credit risk in the residential market as far as new bonds being made today. Okay.

That was great, Ken. I appreciate differentiating it too because I know a lot of the times our clients, they have a tendency to look at things such as the GFC and not realize how much things have changed. I think they've gotten a very...

It's sort of a wake-up call in terms of individuals and consumers locking in at these lower mortgage rates. We're seeing it just given the fact that all the hiking that the Fed has done really didn't damage consumer demand as much. One of the reasons why is because people are holding such a lower mortgage rate than what is out in the marketplace the past year or two. If you have to leave us with some final thoughts, what type of final thoughts do you think our clients and advisors should walk away with? Perfect.

I think with the big run up in equities, I really think that looking at some of these higher yielding parts of fixed income as a complement to your equity portfolio and maybe a place to hide out until we see a more meaningful correction to add back to equities. I think that's something to think about. I think that coming out of the T-bills out a couple of years in the low duration product,

is something to think about locking in that yield in case the market moves the other way and the Fed has to cut more. And then lastly, if you're looking at intermediate-term bond funds, we've seen a big rate backup. So a day like today is a good day to add. Great.

Great. And we'll leave that. Ken, thanks so much again for taking the time. We picked a great day to have you on. And I look forward to having you on this podcast in the very short term. Thanks for having me. Appreciate it.

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