Themes, outlook, and investment implications across global fixed income markets
Principal Fixed Income
Fixed income perspectives
Recession takeoff delayed but not canceled
While the timing of a recession remains uncertain, unique opportunities exist for fixed income investors as we head into the final quarter of 2023.
U.S. outlook
While we agree that a recession does not appear imminent, we strongly believe that further economic slowdown remains on the horizon, ultimately culminating in a recession. The yield curve – which is arguably the most reliable indicator of a recession – has inverted nine times since 1968, of which a recession has followed eight times. Soft landings have only occurred after Fed hiking cycles that were not accompanied by a yield curve inversion.
A close examination of current economic metrics relative to the prior eight inversions does not suggest that this time will be different. Recent economic data is consistent with the evolution in prior inversions/recessions including purchasing managers indices, jobless and continuing claims, nonfarm payrolls, and bank lending.
Global outlook
The third quarter of 2023 was dominated by two themes, the first of which was the growing consensus for a soft landing. As growth data in the U.S. and Europe raised the likelihood that a recession could be avoided, market participants pivoted to pricing for resilience and a rebound in economic growth.
The other dominant narrative involved expectations of tighter-for-longer monetary policy. Policy makers have been consistently hawkish, pushing back against market expectations of rate cuts in 2023 while allowing for some easing in 2024 subject to inflation data.
US 4Q 2023
Recession expectations postponed
As of September 30, 2023. Source: Bloomberg.
Policymakers are likely to remain hawkish, countering market expectations for rate cuts in 2023 and budgeting room for easing in 2024. This should support elevated front-end yields.
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 outlook, 4Q 2023
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.
Solid reserves and balanced budgets should allow U.S. state and local credits to weather economic and revenue pressures. While certain governments remain vulnerable to cyclical vagaries, our outlook on the U.S. state and local government sector remains stable-to-positive under a mild recession scenario.
Despite relatively tight credit spreads, we continue to like state general obligations (GO) as one of the more resilient and defensive municipal sectors. State GOs are largely high-quality, which should help the sector weather an economic slowdown. While there may be limited upside in the near-term at current spreads, we still see value in this sector due to its defensive characteristics and find it attractive going into a more challenging economic environment.
High quality, short-duration consumer asset-backed securities (ABS) remain a compelling opportunity for investors. AAA-rated ABS near the front of the yield curve not only offers an attractive yield but also minimizes exposure to “negative roll” and helps investors limit traditional bond risks, like duration and credit.
The single asset/single borrower (SASB) sector of the commercial mortgage-backed securities (CMBS) market has grown substantially over the past three to four years, now comprising 35% of all outstanding private label CMBS. The SASB market is a mix of floating and fixed-rate deals with a majority in the floating rate space. We continue to like floating rate AAA SASB bonds due to their lack of duration, strong carry, liquidity profile, and ability to dig into the underlying collateral and target favorable credit profiles.
Recent regulatory changes and rate stability driven by a pause in the Fed hiking cycle should produce increased bank demand for mortgage-backed securities (MBS) over the longer term. Agency MBS also enjoy a government guarantee of credit risk, which should bode well if the economy slows into a recession in the coming quarters. Current spread levels allow MBS investors to capture a historically wide yield/spread with a government guarantee of credit risk. These spreads look poised to tighten with the removal of technical supply pressure, normalizing rate volatility, and eventual return of the bank demand the asset class.
Despite an anticipated economic slowdown, we do not believe investors should shy away from high yield. There's been a modest rise in the global default rate since last quarter, however, our baseline forecast remains steady at 4%. Our base case scenario continues to call for wider spreads in high yield and slightly higher default rates. However, high yield offers very compelling return prospects due to strong corporate fundamentals. High yield issuers entered this slowdown with low leverage and extremely strong interest coverage. We expected a slight deterioration in fundamentals due to the interest rate hikes but from extremely strong starting points.
Even assuming we see modest spread widening, the elevated yield environment still generates significant income and a reasonable total return. We understand the argument that spreads are not cheap, but history has shown that these starting yields generate attractive total returns.
Higher rates have made yield the beacon for bondholders and drawn stability-seeking investors toward investment-grade (IG) credit. As of late August, investment grade yields were closing in on heights last seen during the Great Financial Crisis. Put simply, the risk/return profile for corporate bonds appears quite compelling from a yield standpoint.
Spreads—the credit component to IG yields—have remained resilient and resistant to widening as of late. Part of the reason for that has to do with the yield for which investors are yearning. As yield has become the backbone of bond investing, corporate debt buyers are capitalizing on it. We foresee that trend continuing to play out, especially amid the higher-for-longer rate environment. In fact, the longer rates remain elevated, the sharper the focus and larger the appetite of yield buyers, which, in turn, begets bond buying.
Private credit
Emerging market debt
Municipals
Securitized debt
High yield credit
01
While challenges remain, including the uncertain timing of recession and continued economic volatility, we see opportunities in fixed income.
Investment implications
Attractiveness of investment grade corporate bond yield
As of September 28, 2023. Source: Barclays.
Elevated yields typically indicate higher total returns
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Featured insights
Q3 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
As of June 30, 2023. Source: Refinitiv.
1st lien term loan (TL) yield and middle market (MM) yield premium, annual
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
Yield (%)
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Yield premium (%)
2020
2019
2018
2017
2016
2015
2022
Direct lenders MM yield premium
(over large corporate) (RHS)
MM yield premium (over large corporate) (RHS)
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.
2.5
Dec22
Jan23
Feb23
Mar23
Apr23
May23
Jun23
Jul23
Aug23
Sept23
High
yield credit
Securitized
debt
Municipals
Emerging
market debt
Private
credit
View next:
High yield credit
High
yield credit
Securitized
debt
Municipals
Emerging
market debt
Private
credit
Investment
grade credit
IG Corp YTW - Earnings yield (RHS, %)
SPX 1-year forward earnings yield, (LHS, %)
View next:
Securitized debt
0%
5%
10%
15%
20%
25%
As of September 30, 2023. Source: Bloomberg. Data represents Bloomberg U.S. Corporate High Yield Total Return Index Value Unhedged USD.
High quality, short-duration consumer asset-backed securities (ABS) remain a compelling opportunity for investors. AAA-rated ABS near the front of the yield curve not only offers an attractive yield but also minimizes exposure to “negative roll” and helps investors limit traditional bond risks, like duration and credit.
The single asset/single borrower (SASB) sector of the commercial mortgage-backed securities (CMBS) market has grown substantially over the past three to four years, now comprising 35% of all outstanding private label CMBS. The SASB market is a mix of floating and fixed-rate deals with a majority in the floating rate space. We continue to like floating rate AAA SASB bonds due to their lack of duration, strong carry, liquidity profile, and ability to dig into the underlying collateral and target favorable credit profiles.
Recent regulatory changes and rate stability driven by a pause in the Fed hiking cycle should produce increased bank demand for mortgage-backed securities (MBS) over the longer term. Agency MBS also enjoy a government guarantee of credit risk, which should bode well if the economy slows into a recession in the coming quarters. Current spread levels allow MBS investors to capture a historically wide yield/spread with a government guarantee of credit risk. These spreads look poised to tighten with the removal of technical supply pressure, normalizing rate volatility, and eventual return of the bank demand for the asset class.
View next:
Municipals
AAA-rated auto ABS yield curve
Yield (%)
As of August 31, 2023. Source: Bloomberg.
Solid reserves and balanced budgets should allow U.S. state and local credits to weather economic and revenue pressures. While certain governments remain vulnerable to cyclical vagaries, our outlook on the U.S. state and local government sector remains stable-to-positive under a mild recession scenario.
Despite relatively tight credit spreads, we continue to like state general obligations (GO) as one of the more resilient and defensive municipal sectors. State GOs are largely high-quality, which should help the sector weather an economic slowdown. While there may be limited upside in the near-term at current spreads, we still see value in this sector due to its defensive characteristics and find it attractive going into a more challenging economic environment.
View next:
Emerging market debt
Yield-to-worst: State GO Index vs. Municipal Bond Index
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Dec 19
Apr 20
Aug 20
Dec 20
Apr 21
Aug 21
Dec 21
Apr 22
Aug 22
Dec 22
Apr 23
Aug 23
As of September 1, 2023. Source: Bloomberg.
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Municipal Bond Index (LHS)
Municipal Bond: State GO Index (RHS)
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.
View next:
Private credit
Yield to maturity
0
'01
'02
'03
'04
'05
'06
'07
'08
'09
'10
'11
'12
'13
'14
'15
'16
'17
'18
'19
'20
'21
'22
'23
Hover to view difference
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.
1st lien term loan (TL) yield and middle market (MM) yield premium, annual
4.00
9.00
10.00
0.00
0.50
1.00
1.50
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
Large corporate TL yields (LHS)
Direct lenders MM yield premium (over large corporate) (RHS)
As of June 30, 2023. Source: Refinitiv.
8.00
7.00
6.00
5.00
2.00
2.50
3.00
Yield (%)
MM yield premium (over large corporate) (RHS)
MM 1st lien term loan yields (Banks + DL)
MM 1st lien term loan yields (Direct Lenders only) (LHS)
View last:
Emerging market debt
U.S. outlook
While we agree that a recession does not appear imminent, we strongly believe that further economic slowdown remains on the horizon, ultimately culminating in a recession. The yield curve – which is arguably the most reliable indicator of a recession – has inverted nine times since 1968, of which a recession has followed eight times. Soft landings have only occurred after Fed hiking cycles that were not accompanied by a yield curve inversion.
A close examination of current economic metrics relative to the prior eight inversions does not suggest that this time will be different. Recent economic data is consistent with the evolution in prior inversions/recessions including purchasing managers indices, jobless and continuing claims, nonfarm payrolls, and bank lending.
Download full report (PDF)
Nonfarm payrolls (3m moving average) from first inversion to end of recession
Hover over key to isolate by year
Absolute change, 3-month Moving Average NFP Total Net Change Index TCH Index
(Base = first 3m10y inversion)
-800
-600
-200
0
0
5
10
15
20
25
30
35
40
1969
As of August 31, 2023. Source: Bloomberg.
Investment grade credit
02
03
04
05
06
Investment
grade credit
Yield premium (%)
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Axis Label
5.65
5.70
5.75
5.80
5.85
5.90
5.95
6.00
'00
'02
'04
'06
'08
'10
'12
'14
'16
'18
'20
'22
5%
Download full report (PDF)
Download full report (PDF)
Principal Fixed Income
Fixed income perspectives
Themes, outlook, and investment implications across
global fixed income markets
4Q 2023
Featured insights
Download full report (PDF)
Read more
1973
1980
1981
1990
2001
2007
2023
200
400
-1000
= start of recession
-400
Months since first 3m10y inversion
2.5%
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
-1.5%
Dec 22
Jan 23
Feb 23
Mar 23
Apr 23
May 23
Jun 23
Jul 23
Aug 23
Sept 23
Movement of GDP forecast
US 4Q 2023
UK 4Q 2023
EU 4Q 2023
JPN 4Q 2023
Hover over red dot to isolate recession points
IG Corp YTW (LHS, %)
0%
3%
-3%
-5%
-40%
0%
20%
40%
60%
80%
Yield-to-worst (LHS)
Rolling 12-month total return (RHS)
-20%
Weighted average life (years)
Click key below to isloate by year
1969
1973
1980
1981
1990
2001
2007
Click here to view recession overlay
Close recession overlay
1969
1973
1981
1980
1990
2001
2007
Year Key
UK 4Q 2023
EU 4Q 2023
JPN 4Q 2023
2
1.5
1
0.5
0
-0.5
-1
-1.5
2.0%
Movement of GDP forecast
U.S. Treasury 5-year Index
JP Morgan GBI-EM Global Diversified Index
Difference (GBI-EM YTM - UST 5-year)
1
2
3
4
5
6
7
8
9
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
Class A1
Class A2
Class A3
Class A4
'94
'96
'98
'00
'02
'04
'06
'08
'10
'12
'14
'16
'18
'20
'22
'23
Yield to maturity (%)
As of September 30, 2023. Source: JP Morgan, Bloomberg.
U.S. outlook
While we agree that a recession does not appear imminent, we strongly believe that further economic slowdown remains on the horizon, ultimately culminating in a recession. The yield curve – which is arguably the most reliable indicator of a recession – has inverted nine times since 1968, of which a recession has followed eight times. Soft landings have only occurred after Fed hiking cycles that were not accompanied by a yield curve inversion.
A close examination of current economic metrics relative to the prior eight inversions does not suggest that this time will be different. Recent economic data is consistent with the evolution in prior inversions/recessions including purchasing managers indices, jobless and continuing claims, nonfarm payrolls, and bank lending.
Download full report (PDF)
Nonfarm payrolls (3m moving average) from first inversion to end of recession
Hover over key to isolate by year
Absolute change, 3-month Moving Average NFP Total Net Change IndexTCH Index
(Base = first 3m10y inversion)
-1000
-800
-600
-400
-200
0
200
400
Months since first 3m10y inversion
0
5
10
15
20
25
30
35
40
1969
1973
1980
1981
1990
2001
2007
= start of recession
Hover to isolate recession points
1969
1973
1980
1981
1990
2001
2007
2023
As of August 31, 2023. Source: Bloomberg.
6.76
4.61
2.15
'94
'96
'98
'00
'02
'04
'06
'08
'10
'12
'14
'16
'18
'20
'22
'23
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
4
3.5
3
2.5
2
1.5
1
0.5
0
Click here to view difference
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.50
2.00
1.50
1.00
0.50
0.00
6.76
4.6
2.15
5.65
5.70
5.75
5.80
5.85
5.90
5.95
6.00
Yield (%)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Weighted average life (years)
Class A1
Class A2
Class A3
Class A4
Close overlay