Themes, outlook, and investment implications across global fixed income markets
Principal Fixed Income
Fixed income perspectives
Opportunity amid volatility
As we enter 2023, our macro outlook for fixed income revolves around three main drivers:
In 2022, historically high inflation led global central banks to make a series of bold tightening moves. In 2023, we believe this may result in a significant slowing of global growth and, in the U.S., a likely recession by the middle of 2023.
U.S. outlook
It’s our view that inflation may gradually move toward the Federal Reserve’s (Fed) 2% goal over the year. Core goods inflation has made progress during 2022, services have been stickier, and measures of new lease signings suggest that it’s only a matter of time before rent/services inflation makes progress toward the Fed’s goal.
Global outlook
The global outlook for 2023 is one of cautious optimism. With the Fed unable to readily rescue the economy, global policymakers are factoring in a sharp drop in growth to tone down the pace of policy tightening, despite expectations of moderating inflationary pressures. Risk remains as central bank balance sheets have become bloated following a decade of on-and-off quantitative easing and need some release.
Where we've been
Where we are headed
800
-400
-200
0
200
400
600
G10
Brazil
U.S.
Canada
U.K.
South Korea
Euro zone
India
China
Japan
Russia
U.S. CPI Urban Consumers Owner Equivalent Rent of Residences, SA
-0.50
0.00
0.50
1.00
1.50
2.00
2019
2020
2021
2022
Zillow rent index (MoM)
1.00
2.00
3.00
4.00
5.00
6.00
CPI owners equivalent rent (3m annual %)
7.00
8.00
9.00
U.S. Zillow Rent Index, all homes, MoM
Timely measures of rent inflation have likely peaked
Date range: January 2019-October 2022. Source: Bloomberg, Principal Fixed Income.
Major policy rate change 2023 vs. 2022 (bps)
As of December 22, 2022. Source: Bloomberg, Principal Fixed Income.
Elevated
inflation
Restrictive
monetary policy
Rapidly
slowing growth
1
2
3
High yield credit
Municipals
Investment grade credit
Securitized debt
Emerging
market debt
Private credit
Often, heightened volatility presages attractive buying opportunities across fixed income markets. That’s the scenario we find ourselves in at the end of 2022 within investment grade credit. The combination of higher yields and wider spreads, along with stable credit metrics, provides an attractive backdrop for corporate bonds.
We all knew the journey to higher rates was going to be damaging from a total-return standpoint; however, we believe most of the wreckage is behind us, and the magnitude of that movement in U.S. Treasury yields makes the anticipated path ahead promising as yields settle into a more range-bound band. In investing, after all, it matters more what we expect a security or asset class to do tomorrow than what it did yesterday.
Short AAA consumer asset-backed securities and government-guaranteed mortgage-baked securities offer attractive yields and tend to outperform into (and through) recessions.
Asset-backed securities have top credit ratings. And in many cases, they mature in just two or three years—providing cash-flow certainty for investors. Buying ABS amounts to a relatively short-term bet, and the price of the securities isn’t very sensitive to interest-rate changes. These factors make ABS attractive to investors during heightened market volatility.
We find agency MBS attractive. The asset class benefits from government guarantees of credit risk and little-to-no financing risk (even for a large rally in interest rates). MBS spreads have historically outperformed credit into a recession thanks to the government sponsorship of credit risk. MBS is poised to be the spread sector of favor as a recession nears.
As we look into 2023, much has changed in the high yield market over recent years that, in our opinion, should lead to a better outcome for the asset class if the highly anticipated recession comes to fruition. Since the global financial crisis, the credit-quality profile of the high yield market improved progressively and is now at record highs. Other positive factors ought to inform one’s view on high yield credit spreads, such as:
•Increasing levels of secured bonds
•Low default rates with minimal upcoming maturities
•Higher recoveries from defaults
All these currently paint a picture of fundamental strength for the asset class, which warrants historically tighter spreads. Even though spreads aren’t significantly wider over the last decade, the dollar price of high yield bonds is definitely below the average.
As we look into 2023, much has changed in the high yield market over recent years that, in our opinion, should lead to a better outcome for the asset class if the highly anticipated recession comes to fruition. Since the global financial crisis, the credit-quality profile of the high yield market improved progressively and is now at record highs. Other positive factors ought to inform one’s view on high yield credit spreads, such as:
•Increasing levels of secured bonds
•Low default rates with minimal upcoming maturities
•Higher recoveries from defaults
All these currently paint a picture of fundamental strength for the asset class, which warrants historically tighter spreads. Even though spreads aren’t significantly wider over the last decade, the dollar price of high yield bonds is definitely below the average.
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U.S. Zillow Rent Index, all homes, MoM
U.S. CPI Urban Consumers Owner Equivalent Rent of Residenes, SA
-0.50
0.00
0.50
1.00
1.50
2.00
Zillow rent index (MoM)
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
CPI owners equivalent rent (3m annual %)
2019
2020
2021
2022
Download full report (PDF)
Download full report (PDF)
Fixed income outlook, 1Q 2023
High yield bonds vs. leveraged bank loans
Now is the time for investors to reassess return expectations and take a closer look at the relative value of high yield bonds vs leveraged bank loans.
Get our perspective
2023 U.S. investment grade credit supply
As demand exceeds the supply of new debt, 2023 may shape up differently for Investment Grade markets.
Featured insights
The current market presents attractive opportunities for investors as market volatility and economic uncertainty contribute to tighter credit conditions, which in turn contribute to a favorable lending environment. Though recessionary fears, persistently high inflation, rising interest rates, and public market volatility may cause investors to pause when considering a new or incremental allocation to middle-market direct lending, we believe the loans originated during the current and upcoming period will prove to deliver value.
The lower leverage and better credit structure (with meaningful financial covenants) associated with lower and core middle-market companies should provide investors with meaningful benefits, especially when compared to upper middle-market deals. Private middle markets, having less cyclical industry exposure and generally lower leverage than the public market, should offer the opportunity for attractive absolute and relative performance—as has been the case during many prior economic cycles and periods of market volatility.
The global and U.S. cycles continue to be the major drivers for emerging-market (EM) bonds. While the sell-off in 2022 was led by rates moving higher, this period going into a late-cycle U.S. recession is likely to determine the path of credit spreads in 2023. As the largest emerging markets in Asia and Latin America respectively, China and Brazil remain a key focus. In China, the impact of the political transition into policymaking and the ongoing COVID-19 reopening are the major drivers of China’s macro and asset markets. In Brazil, the new Lula government coming into power will dominate market expectations of Brazilian assets.
With additional rate increases and a recession on the horizon, taxable U.S. municipal bonds are particularly attractive investments when measured against other investment grade fixed income asset classes.
After consecutive years of outperforming corporates, 2022 was an underwhelming year for taxable municipal performance—both outright and relative. The primary culprit is the longer-duration characteristic of the asset class in a year during which interest rates rose steadily across the entire maturity spectrum.
The silver lining is that this underperformance sets up well for 2023. Using the JP Morgan JULI index as a guide, 30-year taxable municipal yields are the cheapest since 2013, while spreads measured against corporates are the widest since April 2020.
Short AAA consumer asset-backed securities and government-guaranteed mortgage-baked securities offer attractive yields and tend to outperform into (and through) recessions.
Asset-backed securities have top credit ratings. And in many cases, they mature in just two or three years—providing cash-flow certainty for investors. Buying ABS amounts to a relatively short-term bet, and the price of the securities isn’t very sensitive to interest-rate changes. These factors make ABS attractive to investors during heightened market volatility.
We find agency MBS attractive. The asset class benefits from government guarantees of credit risk and little-to-no financing risk (even for a large rally in interest rates). MBS spreads have historically outperformed credit into a recession thanks to the government sponsorship of credit risk. MBS is poised to be the spread sector of favor as a recession nears.
As we look into 2023, much has changed in the high yield market over recent years that, in our opinion, should lead to a better outcome for the asset class if the highly anticipated recession comes to fruition. Since the global financial crisis, the credit-quality profile of the high yield market improved progressively and is now at record highs. Other positive factors ought to inform one’s view on high yield credit spreads, such as:
•Increasing levels of secured bonds
•Low default rates with minimal upcoming
maturities
•Higher recoveries from defaults
All these currently paint a picture of fundamental strength for the asset class, which warrants historically tighter spreads. Even though spreads aren’t significantly wider over the last decade, the dollar price of high yield bonds is definitely below the average.
Often, heightened volatility presages attractive buying opportunities across fixed income markets. That’s the scenario we find ourselves in at the end of 2022 within investment grade credit. The combination of higher yields and wider spreads, along with stable credit metrics, provides an attractive backdrop for corporate bonds.
We all knew the journey to higher rates was going to be damaging from a total-return standpoint; however, we believe most of the wreckage is behind us, and the magnitude of that movement in U.S. Treasury yields makes the anticipated path ahead promising as yields settle into a more range-bound band. In investing, after all, it matters more what we expect a security or asset class to do tomorrow than what it did yesterday.
Private credit
Emerging market debt
Municipals
Securitized debt
High yield credit
Investment grade credit
The combination of elevated inflation, restrictive monetary policy, and slowing global growth will present unique challenges for investors; however, select opportunities in fixed income remain attractive in our view.
Investment implications
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Option adjusted spread (bps)
Yield-to-worst (%)
6.50
6.00
5.50
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Yield to worst (%)
Option adjusted spread (bps)
11/22/17
U.S. investment grade corporate yields and spreads, past 5 years
Data range: November 22, 2017–November 22, 2022. Source: Bloomberg.
Index represented is the Bloomberg U.S. Corporate Investment Grade Index.
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
11/22/18
11/22/19
11/22/20
11/22/21
11/22/22
Average index price
High yield index price
$110.0
Price
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Option adjusted spread (bps)
2022
10-year price history of high yield index
Data range: September 28, 2012–October 31, 2022. Source: Bloomberg.
Index represented is the Bloomberg U.S. High Yield Index.
2021
2018
2014
2013
2012
2017
2016
2015
2020
2019
Option adjusted spread (bps)
Yield-to-worst (%)
5
MBS richer
Relative value
1990–1994
1995–1999
2000–2004
2005–2009
2010–2014
2015–2019
MBS option adjusted spread vs. investment grade corporate option adjusted spread
Data range: January 1, 1990–October 31, 2022. Source: Bloomberg, National Bureau of Economic Research (“NBER”), Principal Fixed Income.
Indices represented are Bloomberg U.S. MBS Fixed Rate Index and Bloomberg U.S. Aggregate Corporate Index. The shaded areas indicate past recessions.
4
1
0
-1
3
2
MBS cheaper
2020–2024
Corporate rating drift
Municipals rating drift
Notches per credit
2020
2015
2010
2005
2000
1995
1990
1985
1980
1975
1970
One-year drift, U.S. municipal issuers vs. global corporate issuers,1970-2021
Data range: January 1, 1970–January 1, 2021. Source: Moody’s Investors Service.
-0.8
-0.6
0.4
-0.4
-0.2
0.0
0.2
Data range: December 31, 2021–October 31, 2022. Source: Bloomberg.
0
100
200
300
400
500
600
700
800
10/31/22
9/30/22
8/31/22
7/31/22
6/30/22
5/31/22
4/30/22
3/31/22
2/28/22
1/31/22
12/31/21
CEMBI Broad Brazil STW
CEMBI Broad STW
CEMBI broad spread to worst (STW)
CEMBI Broad China STW
As of June 30, 2022. Source: Bloomberg U.S. Corporate High Yield Bond Index, Cliffwater Direct Lending Index, and S&P/LSTA Leverage Loan Index.
Sharpe ratio
(3Q 2004–2Q 2022)
COVID-19
(4Q 2019–1Q 2020)
Great recession
(2Q 2008–4Q 2008)
2.90
-5%
-8%
Direct
lending
0.37
-13%
-27%
High
yield
0.03
-13%
-30%
Syndicated
loans
CEMBI Broad Brazil STW
CEMBI Broad China STW
CEMBI Broad STW
Drawdowns
Date range: January 2019-October 2022. Source: Bloomberg, Principal Fixed Income.
-0.50
0.00
0.50
1.00
1.50
2.00
Zillow rent index (MoM)
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
CPI owners equivalent rent (3m annual %)
2019
2020
2021
2022
U.S. Zillow Rent Index, all homes, MoM
U.S. CPI Urban Consumers Owner Equivalent Rent of Residences, SA
Timely measures of rent inflation have likely peaked
$105.0
$100.0
$95.0
$90.0
$85.0
$80.0
$110.0
Download full report (PDF)
Download the full report (PDF)
Featured insights
Download (PDF)
Featured insights
1Q 2023
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Get our perspective
Get our perspective
High yield bonds vs. leveraged bank loans
Now is the time for investors to reassess return expectations and take a closer look at the relative value of high yield bonds vs leveraged bank loans.
2023 U.S. investment grade credit supply
As demand exceeds the supply of new debt, 2023 may shape up differently for Investment Grade markets.
Get our perspective
Multi-sector fixed income 2023
Improving inflation, a Fed pause, and recession fears suggest that duration should work in investors’ favor in the near-term.
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