Themes, outlook, and investment implications across global fixed income markets
Principal Fixed Income
Fixed income perspectives
Economic turning points
With the first quarter of 2023 behind us, some economic tides are starting to turn.
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
U.S. credit spreads continue to be highly correlated to market pricing for the terminal Federal Funds rate. Recently, credit spreads have tended to rally as the market anticipates a Federal Reserve (Fed) pause and widen as peak rate expectations are repriced higher. As a Fed pause becomes more evident over the second quarter, we believe risk assets will enjoy another relief rally, similar to July 2022.
Global outlook
As we enter the second quarter, global fixed income markets remain volatile. The globally systematically important banks’ (G-SIBs) actions to shift deposits back to troubled banks showed that liquidity remains abundant in the system even as individual institutions faced stress. That said, the probability of a recession is higher now due to banks tightening their belts in the face of more expensive capital. This has indirectly helped central banks achieve their objective to ease price pressures by curbing demand. Looking beyond the current volatility, this likely sets up a remarkably positive technical and fundamental environment for the global fixed income market.
As of December 2022
As of February 2023
U.S.
U.K.
EU
Bloomberg High Yield OAS (LHS)
0
500
1000
1500
2000
1994
2000
2006
2012
bps
0%
1%
2%
3%
4%
5%
6%
7%
Fed Funds Rate (RHS)
Historical U.S. high yields spreads, Fed Funds rates and recessionary periods
As of March 22, 2023. Source: Bloomberg.
Central Bank terminal rates repriced
As of March 24, 2023. Source: Bloomberg.
After a year of aggressive central bank tightening, the peak policy rate for the cycle is likely on the near-term horizon, which has important implications for fixed income investors.
Historically, a pause in the hiking cycle marks a turning point in duration, creating a tailwind for fixed income.
As peak policy rates come into focus, risk assets may enjoy a relief rally initially, but spreads are likely to come under renewed pressure later in the year as recession fears grow.
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
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Fixed income outlook, 2Q 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
Even as public markets continue the year-end 2022 rally into 2023, opportunities remain attractive for investors in middle market private credit. Private credit lenders are focused on more resilient industries and borrowers while requiring relatively low leverage on newly originated transactions along with tighter credit terms and attractive pricing for investors. Having less cyclical industry exposure and generally lower leverage than the public market, the private middle 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 issuance slowdown in 2022, gave way in early January as several large deals launched in the private IG credit market, putting 2023 volume on a record pace. To us, this is an indication that the IG private credit market is returning to pre-pandemic activity levels which should support issuance volume.
Fueled by China’s reopening story and the market’s expectation for peak U.S. inflation, performance was strong for emerging market debt to start the year. As the first quarter progressed, we saw the risk rally subside, as markets reassessed the impact of China’s reopening on Chinese assets as well as the prospective beneficiaries in Asia and globally.
Mexico, has managed to largely avoid inflationary and rate pressures due to structural considerations, shifting geopolitics, and supply chain. Among Latin American peers, Mexico features the increasingly rare combination of relative political stability and fiscal probity. Longer-term, Mexico stands to benefit from the bipartisan U.S. demand for nearshoring of supply chains.
The economic ripple from the pandemic slowdown and the lack of market access has quickly pushed frontier emerging markets into the default group. As global financial conditions tighten, we continue to see several frontier sovereigns struggling to address both domestic economic conditions as well as domestic/external debt loads.
We see an opportunity growing in the municipal market’s sustainability-linked sector, which is drawing increasing investor demand and issuance. ESG considerations are particularly important for municipal bond investors interested in investing in bonds that align with their values and contribute to positive social and environmental outcomes.
We expect the taxable U.S. municipal sector to continue to perform favorably versus taxable alternatives as we head into the second quarter of 2023. If we’re correct in forecasting a downturn in 2023, stable municipal rating transitions and better historical default metrics add to the appeal of the asset class, as has been particularly evident in past recessionary periods.
The spread relationship between investment grade credit and mortgage-backed securities (MBS) still holds as we look to the second quarter of 2023; with current coupon spreads for MBS trading in-line relative to investment grade credit OAS.
The fundamental and technical environment within the MBS market remains stable as there is little-to-no financing risk (even if the market faces a large rally in interest rates) and slowing house price appreciation/housing activity continues to reduce organic net supply. Through most of the Fed hiking cycle, MBS spreads closely followed implied volatility, peaking in March 2023.
Commercial mortgage-backed securities (CMBS) have dislocated from broader credit in response to fundamental concerns around office properties and constrained availability of capital. Regional banks hold a significant share of outstanding commercial mortgages and are likely to scale back on future lending which could exacerbate a drop in real estate values.
Risk assets, like high yield, have generally experienced challenged performance during historical economic slowdowns; however, we believe the fundamental strength of the high yield sector entering this expected slowdown has the asset class better positioned to weather recessionary pressures than in the past. As we look to the second quarter of 2023, there are three key factors supporting the fundamental picture for high yield:
1 . The credit quality of the high yield index today is well above its historical average.
Leverage and interest coverage are stronger than ever for the asset class, and the ability to service debt is not a pressing concern for the asset class.
2. In previous economic downturns, a sector typically experienced tremendous pressure; we don’t see that sectoral pressure building today.
Even with recent back failures/mergers high yield has very limited direct exposure to the bank sector and will be less immediately impacted than other asset classes.
3. The lack of a looming maturity wall
For the remainder of 2023, only $32B of high-yield bonds and $17B of bank loans are set to mature
The rapid ascent in risk-free rates last year left an indelible mark in investors’ minds. The tripling in Treasury yields left corporate bond yields prime for investment. More recently, investment grade corporate (IG) spreads have widened due to heightened risk premia tied to some isolated and idiosyncratic bank issues. Notwithstanding the wider spreads, IG yields remain a ballast for bond investors.
IG corporate bond spreads now comprise 27% of the total yield, low in absolute and relative terms, and before the recent widening in March, the lowest percentage of the total since 2007. This should give yield buyers confidence as over 70% of the yield from corporate bonds is risk-free (i.e., U.S. Treasuries). As these higher yields attract buyers, the spread should remain relatively resilient and contained. That fortuitous factor should sit well with investors considering corporate bonds and serve to anchor demand.
Private credit
Emerging market debt
Municipals
Securitized debt
High yield credit
Investment grade credit
While challenges remain, including the growing threat of recession and continued economic volatility, expectations for softening economic data and a likely Fed rate policy shift should create opportunities in fixed income.
Investment implications
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Option adjusted spread (bps)
Key Title
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Yield to worst (%)
Option adjusted spread (bps)
January 2006
IG corporate spread as a percentage of yield
As of March 30, 2023. Source: Bloomberg.
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
Key
5.50
2022
High yield interest coverage
As of November 1, 2022. Source: Morgan Stanley Research, Bloomberg, Capital IQ, the FTSE Fixed Income LLC.
2020
2014
2006
2004
2002
2012
2010
2008
2018
2016
Implied rate volatility (LHS)
MBS current coupon spread to UST (RHS)
220
2013
2015
2017
2019
MBS coupon spread and implied rate volatility
As of February 28, 2023. Source: Bloomberg.
140
80
60
40
120
100
2021
Corporate rating drift
Municipals rating drift
Notches per credit
2020
2015
2010
2005
2000
1995
1990
1985
1980
1975
'22
State and local governments put effort behind ESG push
As of January 2022. Source Bloomberg. Note: Long-term muni bond sales with green, social, or sustainability indicators.
0%
10%
60%
20%
30%
40%
50%
As of February 2023. Source: Principal Fixed Income, Bloomberg.
0.90
0.95
1.00
1.05
1.10
1.15
02/2023
11/2022
10/2022
09/2022
08/2022
07/2022
06/2022
05/2022
04/2022
03/2022
02/2022
Indonesian rupiah
Mexican peso
Mexican peso relative value to USD vs. selected EM currencies value to USD
Brazilian real
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
5.00
4.50
4.00
3.50
3.00
2.50
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Download the full report (PDF)
Featured insights
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Featured insights
2Q 2023
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2018
6.00
6.50
6.19
2023
160
180
200
2.00
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
Title
Title
Title
01/2023
12/2022
Indian rupee
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -- - - - - - - - - - - - - -
As of March 24, 2023
4.85
4.50
3.65
3.25
3.50
4.60
4.70
5.38
5.00
2023
2021
2019
2017
2015
2013
2011
2009
2007
Effort to go green
'21
'20
'19
'18
'17
'16
'15
'14
% of ESG munis with outside verification
0%
10%
20%
30%
40%
50%
60%
'22
'21
'20
'19
'18
'17
'16
'15
'14
% of ESG munis with ongoing reporting
'23
70%
80%
90%
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Defined benefit plans have patiently waited for the long-dated interest rate to rise. The time may be here to de-risk by swapping out equity-like exposure in favor of fixed-income assets.
Fixed income
•
7 min read
Title
Title
1996
1998
2002
2004
2008
2010
2014
2016
2020
2022
Recession
Notable spread peaks
As of March 22, 2023. Source: Bloomberg.
0
500
1000
1500
2000
bps
0%
1%
2%
3%
4%
5%
6%
7%
Title
1994
2000
2006
2012
Fed Funds Rate (RHS)
Bloomberg High Yield OAS (LHS)
Historical U.S. high yields spreads, Fed Funds rates and recessionary periods
As of February 2022
As of December 2022
U.S.
U.K.
EU
As of March 24, 2023. Source: Bloomberg.
Central Bank terminal rates repriced
Option adjusted spread (bps)
Key Title
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Yield to worst (%)
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Option adjusted spread (bps)
January 2006
IG corporate spread as a percentage of yield
As of March 30, 2023. Source: Bloomberg
As of November 1, 2022. Source: Morgan Stanley Research, Bloomberg, Capital IQ, the FTSE Fixed Income LLC
Average index price
Key
5.00
4.50
4.00
3.50
3.00
2.50
2022
2020
2018
2016
2014
2012
2010
2008
2006
2004
2002
High yield interest coverage
As of February 28, 2023. Source: Bloomberg.
Implied rate volatility (LHS)
MBS current coupon spread to UST (RHS)
220
140
120
100
80
60
40
2013
2015
2017
2019
2021
MBS coupon spread and implied rate volatility
As of January 2022. Source Bloomberg. Note: Long-term muni bond sales with green, social, or sustainability indicators.
0%
10%
20%
30%
40%
50%
60%
'22
Corporate rating drift
Municipals rating drift
State and local governments put effort behind ESG push
As of February 2023. Source: Principal Fixed Income, Bloomberg.
0.90
0.95
1.00
1.05
1.10
1.15
02/2023
11/2022
10/2022
09/2022
08/2022
07/2022
06/2022
05/2022
04/2022
03/2022
02/2022
Indonesian rupiah
Brazilian real
Mexican peso
Mexican peso relative value to USD vs. selected EM currencies value to USD
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Normalized against February 2023
MM 1st lien term loan yields (Direct Lenders only) (LHS)
MM 1st lien term loan yields (Banks + DL) (LHS)
Large corporate TL yields (LHS)
2013
2014
2021
3.25
3.65
3.50
4.50
4.60
4.70
4.85
5.38
5.00
As of December 31, 2022. Source: Refinitiv. Above are the current views and opinions of Principal Global Investors and are not intended to be nor should they be relied upon in any way as a forecast or guarantee of future events regarding particular investments or the markets in general.
1st lien term loan (TL) yield and middle market (MM) yield premium, annual
4.00
6.00
7.00
8.00
9.00
10.00
Yield (%)
0.50
1.00
1.50
2.00
2.50
3.00
Yield premium (%)
5.00
0.00
2020
2019
2018
2017
2016
2015
2022
Direct lenders MM yield premium
(over large corporate) (RHS)
MM yield premium (over large corporate) (RHS)
Normalized against February 2023
20
20