Introduction

Now’s the time to focus on fixed income over equities, according to UBS. The stock market had a strong first half of the year , with the S & P 500 rallying 15.9%, the Dow Jones Industrial Average gaining 3.8% and the Nasdaq jumping 31.7%— it’s best first half since 1983. However, UBS’ base case is that the economy will slow and will enter a mild recession later this year or early 2024, the firm’s chief investment office said in a note last week. “While better-than-expected corporate earnings have been supportive of equity markets this year, there is less scope for these trends to continue,” senior fixed income strategist Frank Sileo wrote. Instead, the firm sees a better risk-reward proposition from quality bonds. “With the Fed on pause and rates peaking, we like a barbell approach to fixed income allocations, combining high-quality, short-duration bonds for income with long-duration bonds to benefit from rate declines,” said Jason Draho, head of asset allocation Americas. Yet some fixed income products are more attractive than others right now. Here are some of those UBS rates “most preferred.”

Mortgage-Backed Securities

UBS calls mortgage-backed securities a “unique” opportunity in fixed income. The cash flows from mortgage-backed securities are tied to the principal and interest payment on a pool of mortgages. The current coupon yield of 5.5% sits near the 98th percentile of the last 10 years, and the AAA-rated sector has a current coupon spread at investment-grade corporate BBB levels, UBS said. “The widest spreads in the sector since the [global financial crisis] have caught the eye of money managers and hedge funds and we expect material tightening into year end,” the firm wrote.

U.S. Investment Grade Credit

Not only can investors earn a decent yield with these corporate bonds, but the assets should also continue to perform well even in a mild recession, UBS said. “IG yields that are in the mid 5% range across maturities provide the opportunity to lock in coupon income for the longer term, while also providing a buffer for any spread widening that may materialize,” the firm wrote. UBS maintains a barbell allocation of both short end and intermediate parts of the curve and continues to see opportunities in the big six bank bonds.

Preferred Securities

Banks and financial institutions issue the majority of preferred securities, which have characteristics of both stocks and bonds. They trade on exchanges, but they have a face value and pay dividends like bonds. UBS recently upgraded preferred securities to most preferred. While concerns over the regional banking sector have dissipated, pricing hasn’t fully recovered from losses incurred in March and early May, Sileo said. “We may see more volatility and episodic drawdowns in the months ahead if concerns resurface over further Fed rate hikes, continued banking stress, or recession risks and loan losses. But current valuations provide attractive entry points, with the potential for impressive 12-month returns, even in a somewhat recessionary scenario,” he wrote. The firm favors a coupon barbell strategy with relatively high coupons of around 6% with medium coupons of roughly 5%. It also likes fixed-to-floating rate coupons, as well as laddered call dates.

Conclusion

UBS believes that now is the time to prioritize fixed income investments over equities. The firm expects the economy to slow and possibly enter a mild recession, making quality bonds a better risk-reward proposition. Among the fixed income products, UBS rates mortgage-backed securities, U.S. investment grade credit, and preferred securities as the most preferred options. These investments offer attractive yields and potential for returns even in a recessionary scenario. With the Fed on pause and rates peaking, UBS recommends a barbell approach to fixed income allocations to take advantage of both short-duration and long-duration bonds.

Source: AsumeTech’s Michael Bloom contributed reporting.