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

Principal Fixed Income

Fixed income perspectives

Looking ahead at 1Q 2024: A turning point for policy

As central banks reach a fulcrum point in monetary policy, we see recessionary pressures mounting over the first quarter of 2024:

U.S. outlook

Over the course of 2023 we’ve witnessed a steady decline in core PCE, the Federal Open Market Committee’s (FOMC) preferred measure of inflation. This downward trend is likely to persist in 2024 as the U.S. economy slows and shelter inflation continues to cool. The downward trend in inflation has bolstered market confidence that monetary policy is now sufficiently restrictive as to achieve the FOMC’s longer run goals. Historically, the final rate increase of a hiking cycle has been a reliable guidepost for interest rates in which duration transitions cyclically from being a headwind to a tailwind for bonds. Early indications suggest that this time will be no different, as an appetite for duration has seemingly returned and investors that had been awaiting further clarity on the path of Fed policy are now returning to the market.

Global outlook

While peak policy rates appear to be behind us, economic tightening is far from over. Using mortgage rates to proxy consumer borrowing costs and corporate bond yields to proxy business borrowing costs, the gap between the existing cost of funding and the current cost of funding is around 200 basis points (bps) across the U.S., U.K., and EU, a level unseen since the 1980s. A higher cost of funding only kicks in upon refinancing, bringing about additional tightening even as policymakers remain on hold. The impact of tightening would come at a politically sensitive time, as 2024 is a major election year with the U.S. presidential election in November, the EU parliament election in June, the U.K. general election by January 2025, and the Japan general election by October 2025.

As of September 30, 2023. Source: Bloomberg.

After steadily declining in 2023, inflation is likely to continue cooling over the first quarter of 2024.

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

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Zillow rent index (MoM)

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CPI owners equivalent rent (3m annual %)

2019

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Fixed income perspectives, 1Q 2024

Though public markets rallied through much of 2023, opportunities remain attractive for investors in middle-market private credit. With an uncertain macro environment and less stable credit conditions, it is important for direct lenders to be diligent and assess the actual underlying credit risk of prospective borrowers while overlaying expectations for more challenging economic conditions. Over the coming quarters, recessionary fears, high inflation, and public market volatility may cause investors to pause when considering an allocation to middle-market direct lending. However, we believe the loans originated during the current and upcoming period will deliver value. Investment-grade private credit year-over-year deals vs. 2022 are down an estimated 20%; however, we expect flow volume to increase pace in Q4 after a slow summer. We are seeing more data center investment opportunities. As bank balance sheet capacity for data center credit risk becomes stretched, banks are considering various structures including private ABS, project finance, credit tenant leases, and real estate investment trusts for the most efficient way for borrowers to raise debt capital.

In China, negative sentiment from the property sector, the collapse in local government revenues, sharp drops in credit demand, and recent issues in the wealth management trust industry have all weighed on the macro backdrop. Across broader EM, there is a divergence in growth, inflation, and the likely speed of policy actions. Within this varied macro backdrop across broad EM markets, flows turned consistently negative. Local EM markets have proven resilient and local bond yields have significantly compressed relative to U.S. yields with risk premia now leaving very little cushion. As we move forward, EM policymakers will be challenged to balance their domestic growth outlooks, rate trajectories, and foreign exchange dynamics all while the larger EM market keeps an eye on China’s macroeconomic policy response and potential global GDP secondary impacts.

U.S. financial assets experienced a sudden and favorable rebound in prices during the final two months of 2023. Much of this rebound can be attributable to money returning to fixed income after inconsistent demand for most of the year. To those clients looking to increase allocations to IG credit, we view taxable U.S. municipal bonds as an attractive complement to those credit-centric mandates. Though index-based total returns have been similar over 2023, taxable municipal spreads still provide an income advantage when compared to similar maturity corporates. Ten-year taxable municipal spreads are wider than AA-rated corporate spreads while yielding about the same as A-rated corporate spreads. Though credit spreads are not as wide as a year ago, but we still see a relative value opportunity in 2024.

Fundamentals remain constructive for mortgage-backed securities (MBS), as cash flows are stable with minimal refinancing risk even if rates rally further in the first quarter. Valuations have also been attractive, as mortgages are trading with spreads well above historical averages, more in line with prior periods of severe stress. Mortgages appear cheap relative to Treasurys and IG credit. Asset-backed securities (ABS) are likely to face a dynamic landscape in the first quarter of 2024 shaped by competing technical and fundamental factors. A surge in auto-related ABS issuance during the second half of 2023 led to underperformance versus other spread products and the sheer volume of new issue supply ultimately weighed on relative performance, a trend that should continue into 2024 as banks and credit unions remain active issuers. Short-duration ABS, however, remains an attractive investment, boasting higher yields compared to similarly rated alternatives. Commercial mortgage-backed securities (CMBS) continue to demand additional yield for potential recession risk, as evidenced by spreads trading in the 90-95th percentiles going back 20 years relative to comparable fixed income asset classes trading tighter than historical averages. If economic data continues to soften and the market firmly believes the Fed is done hiking, we expect transaction activity to pick up and bring transparency to property valuations.

Despite less robust corporate earnings forecasted in 2024 and the prospect of a more challenging fundamental environment, the strength of balance sheets and above-average yields continue to make high yield (HY) compelling. The asset class should be positioned to potentially provide equity-like returns with bond-like volatility over the next year. The FOMC has indicated that they’ve reached their peak federal funds rate for this hiking cycle, and historical data suggests that following a peak in the fed funds rate, the HY market realizes a 12.3% average return over the following 12-month period. This historical perspective fuels further optimism about the HY market's performance post-interest rate hikes.

With the journey to higher rates now in the rearview mirror, IG credit offers compelling yield on an absolute and risk-adjusted basis, as the technical underpinnings of the market remain strong. As rates begin to fall – and even as they oscillate – the commanding starting point for yields creates the perfect backdrop to drive high single total returns for high-grade corporate bonds. With corporate bond yields near 5.0%, duration acting as a tailwind, and rates at an elevated level (though likely to trend lower over 2024) the path to higher returns in high-grade bonds remains promising. As a bonus, higher all-in yields can cushion spread widening given their tighter relative starting point – a higher and more favorable breakeven factor.

Private credit

Emerging market debt

Municipals

Securitized debt

High yield credit

01

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

Investment implications

Spreads as % of yields – usually low when yields are high

Source: JP Morgan, Bloomberg Finance LP. As of November 28, 2023.

Elevated yields typically indicate higher total returns

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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.

MM LBO volumes and syndicated loan market issuance

Although the labor market is showing signs of achieving a better balance, any sustained increase in unemployment claims would likely signal a recession.

The consumer – resilient over 2023 – will need to continue to contend with stubbornly high (albeit moderating) inflation, higher borrowing rates and tighter lending standards.

Dec22 Jan23 Feb23 Mar23 Apr23 May23 Jun23 Jul23 Aug23 Sept23

High yield credit

Securitized debt

Municipals

Emerging market debt

Private credit

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High yield credit

Securitized debt

Municipals

Emerging market debt

Private credit

Investment grade credit

IG yield (RHS)

Spread as a % of yield (LHS)

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Securitized debt

10%

15%

20%

25%

As of December 21, 2023. Source: Bloomberg. Data represents Bloomberg U.S. Corporate High Yield Total Return Index Value Unhedged USD.

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Municipals

CMBS risk premiums are elevated relative to history and other asset classes

Current spread percentile (1998 - 2023)

Sources: Bloomberg Index Services Limited, J.P. Morgan, Bloomberg, Principal Asset Management. As of November 30, 2023.

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Emerging market debt

Income advantage of taxable municipals

4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%

Dec 19 Mar 20 Jun 20 Sep 20 Dec 20 Mar 21 Jun 21 Sep 21 Dec 21 Mar 22 Jun 22 Sep 22 Dec 22 Mar 23 Jun 23 Sep 23

Source: Bloomberg. As of November 30, 2023.

3.00

Yields on AA corp bonds, 10 years vs Treasurys

Yields on taxable revenue munis maturing in 10 years vs Treasurys

Emerging markets (EM) are set to increase growth outperformance versus developed markets (DM) in 2024, on the back of slowing DM growth and stabilizing EM growth after a resilient performance in 2023 and the reopening of the economy in China. Orthodox policy in many EM nations, management of inflation dynamics with credible monetary policies, and the Fed undertaking a shift in policy sets the stage for a relative bounce in EM debt with many EM countries already experiencing moderating inflation and monetary policy easing. Geopolitically, we expect 2024 to be an intense year of elections across the emerging market countries, with national elections scheduled for 40 countries. Away from the primary EM markets, we also see the potential for select distressed stories to find new life and possibly return to normal trading markets.

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Private credit

Improving economic growth and more manageable inflation outlook in EM

'09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22 '23

In 2023, tightening credit conditions, an uncertain economic environment, and declining enterprise value multiples slowed M&A and leveraged buyout (LBO) activity in the direct lending space. Despite the slowing, middle market direct lending continued to fill the void left by commercial banks and the continued decline in syndicated loan market issuance. While these trends are likely to play out further in 2024, investors have now had over a year to embrace higher interest rates. With less fear of “rate whiplash” investor flows are likely to pick up considerably for middle market direct lending. Increased focus on economically resilient models, more conservative leverage profiles, attractive valuations, more lender friendly transaction terms, and manageable default rates should all create opportunities to enhance risk-adjusted returns relative to historic loan vintages.

MM LBO volumes and syndicated loan market issuance

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Emerging market debt

U.S. outlook

Over the course of 2023 we’ve witnessed a steady decline in core PCE, the Federal Open Market Committee’s (FOMC) preferred measure of inflation. This downward trend is likely to persist in 2024 as the U.S. economy slows and shelter inflation continues to cool. The inflation trend has bolstered market confidence that monetary policy is now sufficiently restrictive as to achieve the FOMC’s longer run goals. Historically, the final rate increase of a hiking cycle has been a reliable guidepost for interest rates in which duration transitions cyclically from being a headwind to a tailwind for bonds. Early indications suggest that this time will be no different, as an appetite for duration has seemingly returned and investors that had been awaiting further clarity on the path of Fed policy are now returning to the market, leading to a pronounced rally in interest rates to end the year.

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Final policy hike tends to indicate a turning point for duration

Hover over key to isolate by term

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1985 - 1989 1990 - 1994 1995 - 1999 2000 - 2004 2005 - 2009 2010 - 2014 2015 - 2019 2020 - 2024

As of December 31, 2023. Source: Bloomberg.

Investment grade credit

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Investment grade credit

Syndicated (%)

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CMBS BBB SASB AAA CMBS A CMBS AA CMBS IG MBS CMBS AAA ABS Corp HY Corp IG S&P 500

Axis Label

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

Jul 89 Jan 92 Jul 94 Jan 97 Jul 99 Jan 02 Jul 04 Jan 07 Jul 09 Jan 12 Jul 14 Jan 17 Jul 19 Jan 22

12%

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Principal Fixed Income

Fixed income perspectives

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

1Q 2024

Featured insights

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Emerging economies real GDP (Annual YoY%)

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Source: Bloomberg. As of September 30, 2023.

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Recession

Federal Funds

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3.90

5.50

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U.K.

Average

Impact of tightening yet to reach most of U.S. households

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Corporate bond yield impacts

Mortgage rate impact

Impact of tightening yet to reach most corporates

U.S. IG market yield - Outstanding average coupon

EU IG market yield - Outstanding average coupon

Average

Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Jan 17 Jan 18 Jan 19 Jan 20 Jan 21 Jan 22 Jan 23

Dec22 Jan23 Feb23 Mar23 Apr23 May23 Jun23 Jul23 Aug23 Sept23

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As of November 10, 2023. Source: Bloomberg.

10%

93%

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Yields on A corporate bonds maturing in 10 years

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35.7

22.4

30.6

12.5

23.8

19.5

57.9

10.9

44.6

3.6

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1985 - 1989 1990 - 1994 1995 - 1999 2000 - 2004 2005 - 2009 2010 - 2014 2015 - 2019 2020 - 2024

Mar 04 Mar 06 Mar 08 Mar 10 Mar 12 Mar 14 Mar 16 Mar 18 Mar 20 Mar 22 Mar 23

Mar 04 Mar 05 Mar 06 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Mar 12 Mar 13 Mar 14 Mar 15 Mar 16 Mar 17 Mar 18 Mar 19 Mar 20 Mar 21 Mar 22 Mar 23

Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 Jan 14 Jan 16 Jan 18 Jan 20 Jan 22 Jan 23

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Jul 89 Jan 92 Jul 94 Jan 97 Jul 99 Jan 02 Jul 04 Jan 07 Jul 09 Jan 12 Jul 14 Jan 17 Jul 19 Jan 22

IG yield (RHS)

Spread as a % of yield (LHS)

IG YTW >5%

Percentage Points

Yields on AA corp bonds, 10 years vs Treasurys

Yields on taxable revenue munis maturing in 10 years vs Treasurys

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Emerging economies real GDP (Annual YoY%)

Source: Bloomberg. As of September 30, 2023.

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Dec 19 Mar 20 Jun 20 Sep 20 Dec 20 Mar 21 Jun 21 Sep 21 Dec 21 Mar 22 Jun 22 Sep 22 Dec 22 Mar 23 Jun 23 Sep 23

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Outstanding mortgage rate - new mortgage rate (bps)

-4%

U.S., Europe IG corporate coupon - market yield (%)

Outstanding mortgage rate - new mortgage rate (bps)

U.S., Europe IG corporate coupon - market yield (%)