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

Principal Fixed Income

Fixed income perspectives

Policy volatility meets income opportunity

As we enter the second half of the year, interest rates will likely see a more bullish trend driven by slower economic growth and accelerated expectations for a resumption of Fed rate cuts. Over time, this should lead to returns consistent with the long-term averages of the asset class. As most of the return from fixed income is duration-dependent, investors should look to parts of the fixed income market, such as investment grade and securitized credit, that are higher quality but still more sensitive to interest rate risk.

U.S. outlook

The U.S. economy enters 2025 as a standout performer globally, demonstrating remarkable resilience despite headwinds. Robust consumer spending continues to drive economic growth, supported by historically elevated federal deficit spending, strong wage gains, and wealth effects from stock market gains and stable housing prices. While the labor market is gradually cooling, with higher unemployment rates and slowing hiring, layoffs remain limited, pointing to measured adjustments rather than sharp downturns. Inflation has shown signs of moderation, particularly in shelter and goods prices, but some services sectors remain stubborn. The Federal Reserve is expected to pursue cautious policy normalization, with gradual rate cuts likely through mid-2025. While the removal of election uncertainty is positive, the incoming Trump administration’s fiscal and trade policies introduce new variables. Tariffs, tax reforms, and reduced immigration could create inflationary pressures and impact labor markets and growth. Despite these uncertainties, attractive yields, resilient fundamentals, and a bumpy but improving inflation environment support a sanguine outlook for fixed income and risk assets.

Global outlook

The EU’s proactive policies are expected to boost growth beyond consensus forecasts, supporting financial markets and enhancing sentiment. This has led the euro to appreciate against the dollar, even as the European Central Bank (ECB) cut rates by 50bps and the Bank of England by 25bps, while the Federal Reserve maintained its rates. This trend continued despite ongoing uncertainty from U.S. tariffs. In the second half of the year, European fixed income markets are likely to continue to outperform. U.S. indicators point to weaker growth, albeit with a recession likely avoided. Still, signs of labor market weakness should allow the Fed to resume rate cuts. Meanwhile, the ECB is nearing the end of its easing cycle. Fiscal policy in Europe aims to mitigate any temporary impacts from tariffs, contrasting with the U.S., which has already seen its fiscal benefits. Investors should remain cautious of potential surprises and risks in the market.

Markets continue to grapple with the competing forces of inflation resilience and slowing U.S. growth as the Federal Reserve (Fed) continues to hold policy steady in pursuit of its dual mandate. Tariff actions will likely trigger bouts of volatility as investors await the transition from trade frameworks to actual trade agreements. As inflation runs above target, investors await a one-off price shock tied to tariffs. In turn, the U.S. economy slows, the stagflationary tilt to the outlook remains, and the U.S. yield curve continues to steepen in response.

Selective Opportunities Across Asset Classes 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 2025

Private Credit enters 2025 with optimism, supported by improving macroeconomic conditions and strong middle market lending dynamics. Deal flow is recovering after years of subdued activity, driven by Federal Reserve easing, improved economic visibility, and a business-friendly policy environment. Borrowers have navigated rate shocks through operational efficiencies, while disciplined credit structures and tight underwriting practices have kept default rates below historical averages. Middle market direct lending offers compelling value, with yield premiums, diversification benefits, and opportunities for capital deployment attracting investors. Robust fundamentals and favorable market conditions position Private Credit to outperform in 2025, delivering strong yields and portfolio diversification. As the asset class evolves, democratization through accessible fund structures will broaden its appeal, ensuring its continued relevance in a dynamic investment landscape.

Emerging Market Debt offers selective opportunities in 2025, with projected growth near 4% and inflation largely contained. However, potential challenges include U.S. trade policies, tariff pressures, and geopolitical risks, such as ongoing conflicts and energy market volatility. Certain EM economies, particularly China and Mexico, may face pressure from U.S. protectionist policies, while other regions stand to benefit from lower oil prices and resilient domestic demand. EM corporates enter the year with solid fundamentals, stronger credit metrics than developed market counterparts, and yields near 6.5%. Active management will be essential, as tight spreads require careful country and sector selection. Despite these challenges, Emerging Market Debt remains a valuable allocation for fixed income portfolios, offering diversification, attractive carry, and potential outperformance through a combination of top-down macro positioning and bottom-up credit analysis.

Municipals offer a compelling combination of high yields, strong credit quality, and diversification benefits as we enter 2025. Decade-high municipal yields enhance the relative appeal of the asset class compared to taxable fixed income, especially given the tax-exempt status, which we believe will remain intact despite political scrutiny. Credit quality across municipals is expected to remain excellent, with more upgrades than downgrades anticipated, and revenue-backed debt likely outperforming general obligation bonds. Issuance in 2025 is projected to reach record levels, driven by infrastructure needs and delayed projects, with transportation and public utilities leading the way. Demand remains robust, bolstered by growth in ETFs, mutual funds, and separate accounts, which are expected to absorb the increased supply. Municipals’ capital preservation and attractive risk-adjusted returns position the asset class as a core holding in fixed income portfolios, with opportunities for strong performance despite potential market volatility.

Securitized Debt is poised to benefit from easing monetary policy, resilient consumer fundamentals, and strong demand for risk assets in 2025. Declining interest rates are expected to moderate delinquencies in asset-backed securities (ABS) and support modest growth in home sales, while RMBS performance should remain stable as homeowners continue to enjoy locked-in mortgage rates well below prevailing levels. Pro-business deregulation and lower rates should ease debt burdens for corporate and commercial borrowers, driving green shoots in the CMBS market despite maturity risks and rising delinquencies in office properties. New issuance across structured credit markets is expected to remain robust, with strong demand from banks and a risk-on sentiment supporting valuations. Despite significant spread tightening in 2024, structured credit remains attractive relative to corporate bonds, offering compelling absolute yields. Opportunities in AAA-rated CLOs and SASB CMBS provide flexibility and attractive spreads, making Securitized Debt a valuable allocation for income and risk-adjusted returns.

The outlook for high yield bonds is evolving amid a mixed macroeconomic environment and lingering risks related to tariffs and geopolitical factors. However, the sector rebounded significantly in Q2 and remains an attractive investment within fixed income, making credit selection critical. After a rally from the early April selloff, spreads have tightened below pre-"Liberation Day" levels. Technical conditions have improved, supported by strong fund inflows and increased issuance from high-quality issuers. With yields above 7%, high yield bonds offer compelling value compared to historical averages. However, fundamentals show slight erosion, particularly among cyclical and tariff-exposed issuers. While default rates are below historical averages, improvements are limited. Still, high yield maintains a favorable carry profile in a moderating inflation environment where rate cuts seem likely. While the market has recovered since April’s dislocation, attractive opportunities persist, especially in defensive sectors. Emphasizing balance sheet quality and free cash flow generation is essential as the economic outlook softens. Investors should stay vigilant in credit selection.

Solid high-grade corporate balance sheets and strong fundamentals create a favorable outlook for investment grade (IG) credit heading into the second half of 2025. While corporate bond spreads have narrowed, opportunities for outperformance remain for credit pickers. IG credit has historically performed well in a balanced growth environment, which should continue. Potential fiscal policy changes, such as deregulation or tax cuts, could further support this trend, especially as the Fed’s monetary policy remains steady. Although gross supply has increased this year, net supply lags significantly behind last year's levels, expected to track about 20% lower due to maturing 5-year notes from spring 2020. With yields around 5%, technical factors should bolster IG credit. The recent tightening of spreads indicates growing market confidence in the economic backdrop, recognizing that slower yet positive growth benefits IG credit. Pockets of opportunity remain, highlighting the importance of active management to identify strong credits at attractive values. Overall, IG credit is poised to perform well amid potentially slowing but positive economic growth.

Private credit

Emerging market debt

Municipals

Securitized debt

High yield credit

01

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

Investment implications

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Featured insights

Q3 2023

Going forward, investor focus should fall on the economy and the opportunistic credit fundamentals within the fixed income market. Slow growth should not be confused with recession, and headline risk and trade sensitivity will likely create wider dispersion among sectors. In this environment, active issuer selection and credit discipline are increasingly important.

Although spreads moved wider immediately after Liberation Day and then narrowed back through the final weeks of the quarter, further tightening is unlikely at this point. Nevertheless, emerging markets, securitized assets, and private credit present attractive risk-adjusted opportunities for long-term investors. Active management remains critical for navigating volatility and uncovering value.

High yield credit

Structured credit

Municipals

Emerging market debt

Private credit

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High yield credit

Structured credit

Municipals

Emerging market debt

Private credit

Investment grade credit

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Structured credit

Structured credit fundamentals are stable but show signs of softening compared to earlier in 2025. While consumer balance sheets remain healthy, serious delinquencies in auto, consumer, and student loan securitizations are rising due to elevated interest rates. Commercial valuations have stabilized, but maturing loans face refinancing challenges, as current financing costs are about 200 basis points above mortgage rates. Technical factors in securitization are balanced. After a pause in April, new issuance has resumed, attracting investor demand for spread and yield. Structured spreads have tightened past pre-Liberation Day levels, but further compression may be challenging amid ongoing policy and macroeconomic uncertainty. A strategy focused on higher-quality assets appears prudent, particularly as economic data is expected to moderate later this year. AAA-rated Single Asset/Single Borrower CMBS and investment-grade ABS with strong structural features present attractive opportunities. A measured increase in risk later this year, anticipating a reduction in market uncertainty and supported fundamentals, seems to be favorable.

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Municipals

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Emerging market debt

The rapid tariff fluctuations have led to cautious optimism for Emerging Markets (EM) in the latter half of 2025. As global trade dynamics shift, EM offers diversification benefits and competitive yields compared to Developed Markets (DM). The IMF and World Bank predict that EM growth will surpass DM by 1.5% this year. EM central banks can respond to disinflation driven by lower energy and food prices, aided by redirecting Chinese exports. Despite rising fiscal risks in regions like Latin America, corporate credit metrics in EM remain stronger than those in DM across investment-grade and high-yield sectors. While geopolitical risks warrant caution, particularly in the Middle East, EM spreads are resilient, maintaining an attractive premium over DM credits despite recent U.S. policy volatility. Historically under-allocated, EM is poised to gain traction as a weaker dollar and slowing growth encourage investment. The shift from USD-denominated to local currency debt enhances flexibility, creating a favorable outlook. Lower global energy and food prices will support these economies, allowing for interest rate cuts, particularly for EM corporates with strong fundamentals.

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Private credit

Private credit entered 2025 with optimism, buoyed by improving macroeconomic clarity and expectations for business-friendly regulatory policies. However, the announcement of tariffs in early April shifted the landscape, temporarily pausing leveraged buyout (LBO) and merger & acquisition (M&A) activities. Recently, negotiations around tariffs and regulatory progress have improved LBO and M&A activity. A strong pace of transactions is likely throughout summer and into autumn. Elevated dry powder in private equity and favorable credit conditions create a supportive environment for M&A and LBO activities. Middle-market direct lending offers attractive opportunities for borrowers and investors. Entering the second half of the year, private credit benefits from rising demand from PE sponsors and expanding investor interest. However, challenges remain, including risks associated with policy implementation and economic disruptions. As rates moderate, middle-market direct lending is positioned to potentially outperform, delivering robust yields and stable fundamentals.

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Emerging market debt

U.S. outlook

Year-to-date market metrics mask significant volatility in fixed income. Treasury rates are slightly lower at the front end and higher at the long end, with stable implied volatility. Credit spreads have remained flat or widened slightly. Focusing on economic fundamentals—such as inflation, labor market conditions, and consumer spending—is crucial, especially amid daily headlines. It would have been tempting to reduce risk after spreads widened post-Liberation Day, but this would have been unwise, as spreads have since retraced much of their widening. The U.S. economy has shown resilience despite uncertainty in 2025. While “soft data” has declined, hard data on labor and consumer spending remains strong, though some softening is expected. As markets navigate tariffs and uncertainty, potential tailwinds like trade agreements and Fed cuts may emerge. Optimism surrounds the long-term outlook for the U.S. economy and fixed income market, making near-term volatility a potential buying opportunity.

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Data as of September 30 2024. Source: Bloomberg, Principal Fixed Income. 1Total returns for representative indices. 2Spread to Treasury. Min, max, and average based on last 10 years. 3Index 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, J.P. Morgan EMBI Global Diversified Index, Bloomberg Asset-Backed Securities 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

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Principal Fixed Income

Fixed income perspectives

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

3Q 2025

Featured insights

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Entering the second half of the year, municipal bonds benefit from high yields due to elevated Treasury rates and significant supply. Most new issuances are longer dated, creating a steeper yield curve than taxable fixed income, which results in a positive slope. Approximately $5 billion of new issuance is expected this summer, a notable increase from last year's negative -$7 billion. Relative performance will depend heavily on fund flows, particularly from exchange-traded funds. Key factors influencing the Muni market include valuations and the budget reconciliation bill. However, a challenging liquidity environment is anticipated in the fall, which may lead to market weakness. Net new supply is expected to show little support until the holidays, with projections of -$1 billion in November and December, significantly less favorable than 2024 and the Muni market’s five-year average. Despite these challenges, ample supply presents unique opportunities. The steep yield curve enhances the attractiveness of longer-term investments, offering compelling valuations relative to taxable peers. Current yields provide substantial relative value, especially considering their tax-exempt benefits. Consequently, municipal investors appear more comfortable with additional risk.

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

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

1.25

8.70

8.19

6.58

5.02

4.68

2.13

1.20

3.84

2.30

211 263 54 80 22 7 -156

720 1100 260 373 325 132 250

-90

321 418 92 122 55 36 -11

1.0 3.5 3.5 1.3 3.6 1.7 0.4 0.9 0.4 0.9

2.8 5.5 6.5 3.1 6.1 3.6 2.4 3.0 2.2 2.4

7.0

4.6

8.9

4.7

4.4

4.5

3.3

MIN

AVG

MAX

5.7 8.7 11.7 6.5 13.1 6.4 6.0 6.0 5.1 4.5

3.8

6.3

4.2

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

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

220

Source: Bloomberg, Principal Fixed Income. Data as of June 30, 2025. 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.

Market environment

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

Performance (YTD, %)

Spread (bps)

Yield to Worst (%)

U.S. Aggregate

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

4.02

4.94

4.57

4.49

4.23

4.17

3.79

3.21

2.93

-0.35

-5% -3% -1% 1% 3% 5% 7% 9% 11%

205 253 54 7 74 22 -156

720 1100 260 132 373 325 250

315 410 92 36 119 55 -17

290

220

MIN

AVG

MAX

1.0 3.5 3.5 1.3 0.9 1.7 0.4 3.6 0.4 3.9

5.7 8.7 11.7 6.5 6.0 6.4 5.1 13.1 6.0 4.5

3.0 5.6 6.6 3.2 3.2 3.7 2.3 6.3 2.6

4.5

6.3

7.1

4.7

4.9

5.0

4.0

7.7

4.4

4.0

MIN

AVG

MAX

= Current Value

Policy volatility: an anticipated one-time inflation shock

Credit fundamentals remain resilient

Valuation resets create opportunity

Structured Credit Spreads

Three-year range as of June 30, 2025 (bps)

Source: Bank of America Securities, Wells Fargo Securities, Bloomberg, JP Morgan, Principal Fixed Income. Data as of July 1, 2025.

ABS Subprime Auto

Looking ahead to 3Q 2025:

2.5

Historical U.S. high yields spreads, Fed Funds rates and recessionary periods

Monetary policy and market volatility The Federal Reserve’s measured approach to rate cuts continues to shape market sentiment,while global central banks are responding to uneven economic conditions with varying policypaths. Uncertainty surrounding inflation persistence and trade policy impacts remains a keydriver of volatility.

-54

-66

ABS Equipment

ABS Consumer Loan

RMBS Jumbo PT

RMBS NQM AAA

CLO BSL AAA

CLO BSL BBB

CMBS Conduit AAA

CMBS Conduit BBB

CMBS SASB AAA

CMBS SASB BBB

63 43 70 129 110 113 248 70 185 122 219

180 145 245 231 260 232 625 179 828 225 376

130

201

180

159

150

163

130

410

303

118

564

440

167

135

300

270

Current

Mean

U.S. outlook

Global outlook

U.S. outlook

Year-to-date market metrics mask significant volatility in fixed income. Treasury rates are slightly lower at the front end and higher at the long end, with stable implied volatility. Credit spreads have remained flat or widened slightly. Focusing on economic fundamentals—such as inflation, labor market conditions, and consumer spending—is crucial, especially amid daily headlines. It would have been tempting to reduce risk after spreads widened post-Liberation Day, but this would have been unwise, as spreads have since retraced much of their widening. The U.S. economy has shown resilience despite uncertainty in 2025. While “soft data” has declined, hard data on labor and consumer spending remains strong, though some softening is expected. As markets navigate tariffs and uncertainty, potential tailwinds like trade agreements and Fed cuts may emerge. Optimism surrounds the long-term outlook for the U.S. economy and fixed income market, making near-term volatility a potential buying opportunity.