Themes, outlook, and investment implications across global fixed income markets

Principal Fixed Income

Fixed income perspectives

Looking ahead at 3Q 2024: A resilient U.S. economy is keeping rate cuts on hold...for now

Despite policy rate cuts remaining elusive, several tailwinds are boosting a resilient U.S. economy. And while the Fed continues to navigate a potential soft landing, global central banks are actively transitioning onto a path of easing policy.

U.S. outlook

The combination of a resilient U.S. economy, improving inflation, attractive starting yields, and the potential for Federal Reserve (Fed) rate cuts presents a healthy backdrop for fixed income. After enduring two years of severe headwinds due to low starting yields and aggressive Fed hiking, the Bloomberg Aggregate Bond Index now offers yields near the top end of its range from the past two decades. However, spreads in most fixed income sectors are near the tight end of their long-term range, making them less attractive from a historical perspective. Robust consumer spending, accounting for ~70% of the economy, has been a key driver of economic resilience, supported by fiscal stimulus, pandemic savings, Social Security adjustments, positive real wages, stock market gains, and a strong labor market. However, signs of stress are emerging, particularly among lower-income households, with moderating real wages, depleted savings, rising non-mortgage interest payments, and increasing consumer delinquencies. This may moderate overall spending through the rest of the year but does not necessarily signal dramatic spread widening in credit sectors. A modest pullback in spending could help with inflation, increasing the probability of Fed rate cuts and potentially supporting credit spreads. While labor market slowing is anticipated, unemployment claims and payroll gains remain robust, suggesting a positive outlook for fixed income given attractive yields and potential duration gains as the Fed normalizes rates.

Global outlook

The theme of higher-for-longer policy rates continued to dominate market expectations in much of the second quarter, as resilient growth and sticky inflation swayed Federal Open Market Committee members to turn more cautious toward policy easing. This led to a strong market reaction in April. To address market concerns, the Fed tapered quantitative tightening to avoid a repeat of the 2019 liquidity shock, while Fed Chairman Jerome Powell highlighted progress in inflation and a cooling labor market. Meanwhile, the European Central Bank (ECB) and the Bank of England (BoE) asserted the independence of their monetary policies, with the ECB cutting rates and the BoE likely to follow. Our global policy outlook, which called for the commencement of the rate cutting cycle by major central banks, remains intact, though with fewer cuts than initially expected. Despite last year’s rate hikes still filtering through the U.S. economy, the market has become more optimistic about global growth since 3Q 2022. The labor market remains a key support for growth and prices in major economies, though five out of 11 major industrialized countries have seen unemployment rates rise significantly, a potential recession indicator known as the Sahm Rule. This suggests rise more than 0.5% above the cycle low. As the November U.S. presidential election approaches, investors should prepare for potential market implications. Historically, U.S. elections focus on domestic issues, potentially desensitizing the market to geopolitical events. The Fed's neutrality over the election could narrow its window for policy adjustments, with market pricing likely influenced by anticipated fiscal policy impacts based on polling outcomes.

Going into 3Q, there is less uniformity in the path forward among central banks; the European Central Bank and the Bank of England are guiding for more rate cuts this year, while rate cuts in the U.S. continue to be delayed and decreased.

With market expectations shifting toward a soft landing, credit spreads are likely to remain rangebound, exhibiting a widening bias as a recession becomes more evident.

Though economic data has been resilient, key market indicators continue to signal an impending recession, and we strongly believe there is further economic slowing on the horizon.

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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

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Fixed income perspectives, 3Q 2024

Deal activity in private equity and private credit markets has picked up in 2024. Despite last year’s slowdown in M&A and LBO activity, middle market direct lending is filling the void left by commercial banks. New loan origination is increasing, primarily financing new opportunities for LBOs and M&A. Deals in the lower and core middle markets reflect strong value, maintaining favorable economics from past transactions due to call protection and original issue discounts (OID). Easing credit conditions are evident, with spreads tighter in public markets and modestly tightened in the private middle market. The current vintage loans offer attractive opportunities with sufficient debt service coverage, conservative leverage profiles, and favorable economics, enhancing risk-adjusted returns. After a busy June for investment grade private placements, the market will likely slow in August before picking up in 4Q. The current pipeline includes significant deals in energy, renewables, technology, and data centers. Relative value to public comparables has compressed but still offers above-average value. Most 3Q deals are expected to be well oversubscribed by investors seeking long-tenor IG private fixed income opportunities. With global investment incentives and strong demand, infrastructure will represent a larger portion of IG private market deals, with issuers favoring tenors under 10 years and investors bidding for 15-year-and-longer notes.

Emerging market (EM) credit has outperformed amid surprising U.S. economic strength, which has delayed the Fed’s easing cycle. Overall, EM credit spreads are notable tighter year-to-date. The strength in the EM debt sector has been driven by positive fundamentals and technical factors, such as developed market economic strength, expectations of U.S. rate cuts, and benign EM sovereign fundamentals. Investors’ underweight positions have offset receding Fed rate cut expectations and periodic U.S. Treasury market volatility. New issuance has slowed after a strong start to the year, with the market still keen to fund new issuance. EM economies have benefited from a strong commodity cycle in 2024. Metals like aluminum, copper, and nickel have thrived due to green energy and AI investments, while crude oil has benefited from geopolitical tensions and strong demand, supported by OPEC+ discipline. However, the prospect of higher-for-longer U.S. rates has complicated matters for EM central banks, delaying their rate-cutting cycles. China, a key EM driver, reported a growth upside of 5.3% year-over-year in 1Q 2024, driven by strong exports and significant policy support for the property sector. These factors have provided positive signals for EM debt investors, who continue to focus on spread compression and elevated yields, finding idiosyncratic opportunities in select corporate issuers and lower-rated countries with orthodox economic policies and IMF engagement. Recent election-related volatility in Mexico, South Africa, and India may also present investment opportunities.

The end of 2023 saw a market where beta was rewarded, with record returns across all sectors as the market anticipated multiple rate cuts in 2024. However, by early January, the market turned hawkish, eliminating the idea of numerous cuts. Inconsistent economic data and stubborn inflation metrics led to rising Treasury rates throughout 2024, impacting municipal benchmark rates. Last year's rate jump either hurt returns or left them stagnant year-to-date, pressuring high yield municipals. High average coupons mitigated this weakness, dampening volatility, and tightening credit spreads augmented prices. Active management remains crucial for navigating the complexities of the credit market and capitalizing on opportunities in the speculative tax-exempt market. There are chances for additional spread compression in the municipal high yield market during the second half of the year. The term structure and back-end steepness of the exempt market offer return potential not available in Treasury tenors, prompting some investors to move away from money markets. Whether inflation stays sticky or a recession emerges, high yield municipals should prosper due to their defensive attributes and longer-duration profiles. Investors can still lock in longer, attractive, tax-free yields, and year-to-date, high yield and non-rated municipals have provided diversification benefits, with greater market depth facilitating liquidity and benefiting bondholders.

Demand for CMBS has kept pace with a larger-than-anticipated supply of new issuance in the first half of 2024. Spreads tightened, and the credit curve flattened, with BBB “on the run” conduit bonds rallying 213 bps compared to AAA bonds tightening by 21 bps. AAA bonds are now fairly priced, but there is still value in lower-rated bonds, especially in single asset single borrower (SASB) deals. Given the expectation for a wide dispersion of credit performance across deals, security selection remains vital to any SASB investment strategy. A broad move tighter will be challenged by headwinds related to refinance risk and office performance. Conduit refinance success rates align with longer-term trends, but there has been significant deterioration in on-time pay-off rates for SASB transactions. Commercial real estate collateralized loan obligations struggle to refinance into a higher-rate environment, especially office loans with only a 36% refinance success rate. Positively, there is no immediate maturity wall, and loan maturities are balanced over the next two years, with fully extended office loans accounting for only 4% of the total outstanding private credit CMBS market. Effective underwriting and forecasting areas of risk and opportunity will be critical to discerning between deals as loan resolutions vary by location, leasing demand, sponsor commitment, and interest rates.

Never mind spread; it’s yield that matters. Many investors focus on credit spreads as a signal for entering or exiting credit markets, but history suggests that timing spread movements is challenging, especially in high yield (HY) credit markets. Yield, however, is a more powerful gauge of HY’s attractiveness. Charting the asset class’s starting yield against its five-year forward annualized returns shows a strong correlation of 0.87, higher than the correlation between starting spread and returns. The substantial income produced by the yield should continue to deliver attractive returns for investors. The shrinking default rate in high yield further boosts confidence that starting yields could translate into attractive returns. With high yield in a historically higher-yielding environment and defaults projected to be below historical averages, investors may be in a particularly strong high yield market. Despite concerns about inflation and slowing economic growth, a widespread rise in defaults is unlikely due to manageable corporate debt maturities and stronger business capitalization post-COVID. The market shift toward higher credit quality, with CCCs making up a smaller portion, means tighter spreads and fewer opportunities to wait for an ideal entry point. The income component, driven by contractual coupons, remains crucial for long-term outperformance, positioning HY as a higher-quality, income-driven asset class poised to potentially deliver long-term returns at current yield levels.

While monetary policy easing may be delayed, dovish remarks by Fed Chairman Powell and softening pricing data create a favorable environment for investment grade (IG) credit. The IG market is optimistic about eventual rate cuts, and the consumer-driven U.S. economy continues to grow steadily, keeping inflation and economic growth balanced. Despite tight valuations, IG credit's compelling yield attracts strong demand, with nearly $800B in issuance in the first five months of 2024 and investor receptivity remaining high. Amid this backdrop, IG credit should benefit from attractive yields and a duration tailwind. With rates 500 basis points (bps) higher than at their trough, the income bonds provide is substantially higher now than a few years ago. As the Treasury yield curve normalizes, investors are likely to extend duration, moving from money market funds to corporate bonds. Ratings quality has improved, with BBBs now almost half of the corporate bond index, giving it a higher quality tilt. While fundamentals have shown slight degradation due to increased leverage, they remain strong with solid 1Q earnings growth of 9.8% year-on-year. With valuations tight, credit picking and curve positioning are crucial, and strong technical factors will likely continue to make high-grade corporate bonds attractive to yield-seeking investors.

Private credit

Emerging market debt

Municipals

Commercial mortgage-backed securities

High yield credit

01

While economic challenges remain, we see opportunities in fixed income.

Investment implications

Credit quality of the investment grade bond index

Source: J.P. Morgan, Bloomberg, Principal Fixed Income. Data as of April 30, 2024.

High yield index yield and 5-year forward return comparison

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Featured insights

Q3 2023

Source: Refinitiv. As of September 30, 2023. *Syndicated Middle Market: Facilities syndicated to at least one participant up to US$500M in deal size or clubbed up to US$150M in deal size. **Direct Lending: Non-syndicated facilities, no non-titled lender. Unitranche and bilateral loans, deals clubbed over US$150M deal size, facilities that go unreported, privately placed second-liens, mezzanine and seller notes.

Middle market LBO volume and percent syndicated

A healthy labor market and resilient consumer have been the most significant part of the U.S. economy propping up growth and prices. However, those components are starting to show signs of cooling, a potential indicator of a more substantial slowdown.

Ahead of potential election-related volatility, many fixed income asset classes are poised for potential outperformance heading into the second half of the year.

High yield credit

Commercial mortgage-backed securities

Municipals

Emerging market debt

Private credit

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High yield credit

Commercial mortgage-backed securities

Municipals

Emerging market debt

Private credit

Investment grade credit

BBB Total

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Commercial mortgage-backed securities

Source: Bloomberg, Principal Fixed Income. Data as of April 30, 2024.

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Municipals

Refinance success rate

Source: J.P. Morgan, Trepp, Principal Fixed Income. Data as of April 30, 2024.

After resounding victories by both party candidates in state primaries and caucus elections to date, markets are starting to ponder the implications of the evolving political landscape as the presidential election has again come to the forefront. Key policy issues will be impacted depending on which party controls the White House and Congress, likely resulting in substantial volatility. With an ever-increasing federal deficit (the highest in U.S. history) revenue will be a priority no matter which candidate and party wins this fall. Individual income taxes, according to the Tax Foundation, are the highest source of revenue for the U.S. We do not see that changing, and we do not see individual tax rates going lower. In fact, we think the opposite, further enhancing the value of the exemption and leading to greater investor demand for the asset class.

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Emerging market debt

Bloomberg fixed income indices

Source: Bloomberg, Principal Asset Management. Data as of June 30, 2024.

Emerging market (EM) credit has outperformed amid surprising U.S. economic strength, which has delayed the Fed’s easing cycle. Overall, EM credit spreads are notably tighter year-to-date. The strength in the EM debt sector has been driven by positive fundamentals and technical factors, such as developed market economic strength, expectations of U.S. rate cuts, and benign EM sovereign fundamentals. Investors’ underweight positions have offset receding Fed rate cut expectations and periodic U.S. Treasury market volatility. New issuance has slowed after a strong start to the year, with the market still keen to fund new issuance. EM economies have benefited from a strong commodity cycle in 2024. Metals like aluminum, copper, and nickel have thrived due to green energy and AI investments, while crude oil has benefited from geopolitical tensions and strong demand, supported by OPEC+ discipline. However, the prospect of higher-for-longer U.S. rates has complicated matters for EM central banks, delaying their rate-cutting cycles. China, a key EM driver, reported a growth upside of 5.3% year-over-year in 1Q 2024, driven by strong exports and significant policy support for the property sector. These factors have provided positive signals for EM debt investors, who continue to focus on spread compression and elevated yields, finding idiosyncratic opportunities in select corporate issuers and lower-rated countries with orthodox economic policies and IMF engagement. Recent election-related volatility in Mexico, South Africa, and India may also present investment opportunities.

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Private credit

Emerging market bond index spread and yield

June '14 June '15 June '16 June '17 June '18 June '19 June '20 June '21 June '22 June '23 June '24

Deal activity in private equity and private credit markets has picked up in 2024. Despite last year’s slowdown in M&A and leveraged buyout (LBO) activity, middle market direct lending is filling the void left by commercial banks. New loan origination is increasing, primarily financing new opportunities for LBOs and M&A. Deals in the lower and core middle markets reflect strong value, maintaining favorable economics from past transactions due to call protection and original issue discounts (OID). Easing credit conditions are evident, with spreads tighter in public markets and modestly tightened in the private middle market. The current vintage loans offer attractive opportunities with sufficient debt service coverage, conservative leverage profiles, and favorable economics, enhancing risk-adjusted returns. After a busy June for investment grade private placements, the market will likely slow in August before picking up in 4Q. The current pipeline includes significant deals in energy, renewables, technology, and data centers. Relative value to public comparables has compressed but still offers above-average value. Most 3Q deals are expected to be well oversubscribed by investors seeking long-tenor IG private fixed income opportunities. With global investment incentives and strong demand, infrastructure will represent a larger portion of IG private market deals, with issuers favoring tenors under 10 years and investors bidding for 15-year-and-longer notes.

Middle market LBO volume and percent syndicated

0.00

10%

20%

30%

2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

% Syndicated

Source: LSEG LPC, Principal Asset Management. Data as of March 31, 2024. *Syndicated Middle Market: Facilities syndicated to at least one participant up to U.S. $500 million in deal size or clubbed up to U.S. $150 million in deal size. **Direct Lending: Non-syndicated facilities, no non-titled lender. Unitranche and bilateral loans, deals clubbed over $U.S. $150 million deal size, facilities that go unreported, privately placed second-liens, mezzanine and seller notes.

30.00

20.00

10.00

40%

50%

60%

MM LBO volume ($B)

Syndicated*

Direct**

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Emerging market debt

U.S. outlook

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Market environment

Year-to-date performance, spread, and yield for various fixed income indices

Source: Bloomberg. As of 30 June 2024. 1 =Total returns for representative indices 2 = Spread to Treasury. Min, max and average based on last 10 years. 3 = Index yield to worst. Min, max and average based on last 10 years. Weighted average yield-to-maturity reflected for U.S. Bank Loans. Indices are unmanaged and do not take into account fees, expenses, and transaction costs and it is not possible to invest in an index. Indices used in order of appearance: Bloomberg U.S. Aggregate Index, S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan 100 Index, Bloomberg U.S. Corp HY 2% Issuer Capped Index, Bloomberg Asset-Backed Securities Index, J.P. Morgan EMBI Global Diversified Index, Bloomberg CMBS ERISA-Eligible Index, Bloomberg U.S. Municipal Bond Index, Bloomberg U.S. Credit Index, Bloomberg U.S. Treasury Index, Bloomberg U.S. MBS Index.

Investment grade credit

02

03

04

05

06

Investment grade credit

Syndicated (%)

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

4.75 to 5.00 5.00 to 5.25 5.25 to 5.50 5.75 to 6.00 6.25 to 6.50 6.50 to 6.75 6.75 to 7.00 7.00 to 7.25 7.25 to 7.50 7.50 to 7.75 7.75 to 8.00 8.00 to 8.25 8.25 to 8.50 8.50 to 8.75

100% 80% 60% 40% 20% 0%

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

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Principal Fixed Income

Fixed income perspectives

Themes, outlook, and investment implications across global fixed income markets

3Q 2024

Featured insights

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Index YTW

CEMBI Broad Div Spread to Worst, bps (LHS)

12% 10% 8% 6% 4% 2% 0%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18

Source: J.P. Morgan, Bloomberg, Principal Fixed Income. Data as of June 6, 2024.

1-3Q

70%

40.00

50.00

60.00

70.00

80.00

90.00

$20.5

$11.6

$18.9

$19.4

$19.0

$23.8

$28.0

$27.1

$20.6

$35.7

$22.4

$30.6

$12.5

$23.8

$19.5

$57.9

$10.9

$44.6

$6.5

$26.5

Source: J.P. Morgan, Bloomberg, Principal Fixed Income. Data as of June 6, 2024.

20% 15% 10% 5% 0%

5 year forward return

5% 4% 3% 2% 1% 0% -1% -2%

U.S. Municipal index U.S. Corporate Index U.S. Treasury Index U.S. Corporate High Yield Municipal High Yield

Year-to-date performance, spread, and yield for various fixed income indices

Bloomberg fixed income indices

2005 2007 2009 2011 2013 2015 2017 2019 2021 2023

Labor market vs. growth forecasts

May 2012-present

-1

May '12 May '13 May '14 May '15 May '16 May '17 May '18 May '19 May '20 May '21 May '22 May '23 May '24

Source: Bloomberg, Principal Fixed Income. Data as of April 30, 2024.

6.00 5.00 4.00 3.00 2.00 1.00 0.00 -1.00 -2.00

12 month ahead growth expectation for major economies (RHS)

# of G10 with unemployment rate increase >=0.5% (LHS)

J.P. Morgan U.S. Liquid Investment Grade Corporate Index, 2015–present

Bloomberg U.S. Corporate High Yield Bond Index

Average Yield: 8.82% Average 5YR Return: 7.56% Correlation: 0.87

By loan type, 2015-present

Total return, January - June 2024

June 2014-present

CEMBI Broad Div Yield to Worst (RHS)

EMBIG Diversified Spread to Worst, bps (LHS)

EMBI Global Diversified Blended Yield (RHS)

800 700 600 500 400 300 200 100 0

$US billions, 2014-2023

>=AA-

A+

A-

BBB+

BBB

BBB-

11%

12%

11%

12%

13%

12%

11%

10%

15%

16%

20%

21%

19%

20%

19%

18%

19%

17%

18%

17%

16%

17%

19%

16%

17%

18%

17%

12%

14%

17%

18%

14%

15%

14%

11%

12%

13%

11%

14%

11%

10%

46%

51%

44%

Conduit

Floating SASB

Fixed SASB

CRE CLO

Performance (YTD, %)

Spread (bps)

Yield to Worst (%)

U.S. Aggregate

U.S. Bank Loans U.S. HY Credit Emerging Market Debt U.S. ABS U.S. CMBS U.S. Municipals U.S. IG Credit U.S. Treasury U.S. MBS

MIN

AVG

MAX

-0.71

4.10

2.59

2.22

1.66

1.53

-0.40

-0.49

-0.86

-0.98

263 211 22 54 -156 80 7

1100 720 325 260 250 373 132

309

-126

420 323 55 92 -9 122 36

1.0 3.6 3.5 3.5 0.4 1.3 0.9 1.7 0.4 0.9

2.8 6.0 6.5 5.5 2.4 3.0 2.3 3.5 2.1 3.0

7.9

7.2

5.3

5.5

3.7

5.5

5.2

MIN

AVG

MAX

5.7 13.1 11.7 8.7 6.0 6.5 4.5 6.4 5.1 6.0

4.6

9.2

5.0

-5% -3% -1% -0% 1% 3% 5%

4.14%

2.59%

-0.86%

-0.49%

-0.40%

J.P. Morgan U.S. Liquid Investment Grade Corporate Index, 2015–present

Average Yield: 8.82% Average 5YR Return: 7.56% Correlation: 0.87%

Bloomberg U.S. Corporate High Yield Bond Index

By loan type, 2015 - present

Total return, January - June 2024

June 2014 - present

$US Billions, 2014 - 2023

Labor market vs. growth forecasts

May 2012 - present

U.S. Bank Loans U.S. HY Credit Emerg.Market Debt U.S. ABS U.S. CMBS U.S. Municipals U.S. IG Credit U.S. Treasury U.S. MBS

262

U.S. Municipal index

U.S. Corporate Index

U.S. Treasury Index

U.S. Corporate High Yield

Municipal High Yield

5% 4% 3% 2% 1% 0% -1% -2%

U.S. Municipal index

U.S. Corporate index

U.S. Treasury index

Corporate High Yield

Municipal High Yield