Sector views

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Floating-rate bank loans

Floating-rate loans outperformed other fixed income markets for the third quarter with a return of 3.43% (as measured by the Morningstar LSTA US Leveraged Loan Index). With loan price dispersion expected to remain elevated, attractive investment opportunities have presented themselves, in our view. That said, prudent credit selection will be an important driver of alpha (excess return on investment relative to the return of a benchmark index). Most non-IG issuers continue to be challenged by shrinking profit margins due to inflationary pricing and a more discerning consumer.

Floating-rate loans continue to provide stability against interest-rate volatility. If inflation remains high, loans may benefit from higher rates, with elevated SOFR (Secured Overnight Financing Rate) levels providing higher yields. On the other hand, if inflation falls, and the Fed begins to reduce rates, floating-rate income will decrease, but prices will generally remain stable, we believe.

Figure 2. Risk assets outperformed in Q3 except for mortgage-backed securities

*Excess returns are calculated relative to comparable-maturity U.S. Treasuries for each index. Excess return does not always mean “outperformance.”

Source: Bloomberg, as of 9/30/23. Indexes are unmanaged and do not incur expenses. You cannot invest directly in an index. Past performance is not indicative of future results. High-yield bonds are represented by the Bloomberg U.S. Corporate High-Yield Index, which covers the U.S. dollar-denominated, non-investment-grade, fixed-rate, taxable corporate bond market and includes securities with ratings by Moody’s, Fitch, and S&P of Ba1/BB+/BB+ or below. EM (emerging market) debt is represented by the Bloomberg EM Hard Currency Aggregate Index, which is a flagship Emerging Markets debt benchmark that includes USD, EUR, and GBP denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. U.S. IG (investment-grade) corporate debt is represented by the Bloomberg U.S. Corporate Index, a broad-based benchmark that measures the U.S. taxable investment-grade corporate bond market. CMBS (commercial mortgage-backed securities) are represented by the Bloomberg U.S. CMBS Investment Grade Index, which measures the market of commercial mortgage-backed securities with a minimum deal size of $500 million. Agency MBS (mortgage-backed securities) are represented by the Bloomberg U.S. MBS Index, which covers agency mortgage-backed pass-through securities (both fixed-rate and hybrid adjustable-rate mortgages) issued by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

Corporate credit

We have a cautious view on the corporate credit market, although we continue to find pockets of idiosyncratic opportunities across the risk spectrum. Corporate fundamentals were strong entering 2023 and remained resilient based on earnings results through the second quarter. Margins, leverage, and balance sheet health are slightly off their peaks but are still near decade highs. Given the strength in earnings and resulting implications for the health of consumer spending, we do not believe a recession is imminent absent further distress in the financials sector.

We believe technicals in high-yield and investment-grade credit are strong, driven in large part by a persistent bid from pension and liability-based buyers taking advantage of higher yields and lower prices after this year’s rate sell-off. Spread valuations are largely reflective of a non-recessionary economy, which leaves little room for earnings volatility. All-in yields (which are calculated based on spreads as well as rates), however, create an attractive total return backdrop, which should be supportive. Still, macro forces of high inflation, tight central bank policy, and tighter credit conditions remain considerable risks to both fundamentals and market technicals. As a result, we are positioned for slower growth as we enter 2024.

Commercial mortgage credit

The commercial real estate sector is facing meaningful headwinds and increased risks, including the effects of a post-pandemic shift in office demand and rising costs of capital. Property values will likely face pressure over the medium term, but prices will vary significantly by geography and property type. However, this scenario is more daunting for the equity investor, in our view. Debt holders only need the borrower to pay off the remaining interest and principal owed, which we believe limits the impact on commercial mortgage-backed securities. We believe much of this risk is already reflected in the market given the significant spread widening in the last year and a half. The most attractive relative value opportunities require detailed loan-level analysis and security selection, in our view.

Residential mortgage credit

We believe U.S. homeowner balance sheets are well positioned. Many homeowners are benefiting from locked-in, ultra-low mortgage rates and substantial home price appreciation in recent years. We expect home prices to remain stable for the rest of 2023. However, certain locations that became overheated may be susceptible to retractions, in our view. While sector spreads have tightened compared with 2022, they remain wider compared with 2021. At current levels, we believe attractive risk-adjusted return opportunities can be found across the capital stack.

Prepayment

We expect prepayment speeds will be stable going forward. The sector may provide helpful protection against a recession scenario that negatively impacts home prices or employment. In our view, many prepayment-sensitive assets now offer an attractive risk-adjusted return at current price levels and significant upside potential if rates stabilize and volatility declines.

Tax exempt

We continue to find opportunities across the municipal bond market, uncovering value in rating, sector, and coupon dislocations. Municipal credit fundamentals remain stable, in our view. Higher employment and increasing wages have bolstered tax receipts in the past few years. We continue to monitor the housing market, including home values, an important factor in property tax revenues.

Total state and local tax collections fell 7.30% in the first half of 2023 compared with the first half of 2022. At the same time, total tax revenues are nearly 16% above their five-year average. Also, state and local governments’ rainy-day funds and financial reserves are close to 30-year highs. Municipal defaults through September are down 28% versus the average of the past five years and continue to represent a very small percentage of the market. As such, we believe the credit outlook remains favorable, though we continue to actively evaluate credit conditions.

Current valuations are attractive, in our view. At the close of quarter-end, taxable equivalent yields were close to 7.00%, suggesting municipal bonds were relatively cheap on a long-term basis. We regard any market volatility as an investment opportunity and continue to be vigilant for dips in the market that can present attractive entry points.

Emerging market credit

We remain cautious on our intermediate outlook in EM, although we are beginning to see recession risks and inflation risks declining for now. China’s expected recovery has been disappointing, challenging the idea of a sustained recovery. Additionally, escalating geopolitical tensions could add to sticky inflation and have a negative impact on risk assets if the situation worsens. However, the global growth outlook does not appear as challenging as we expected earlier in the year. While we anticipate some adjustment in monetary policy should a severe slowdown materialize, central banks will be somewhat constrained as long as inflationary pressures remain, in our view.

Regardless of the policy path, we continue to believe higher-grade EM names are overvalued given the current environment, even with recession and inflation risks declining, although the latter condition should be supportive of EM over the near term. Distressed names now also appear relatively rich given the current market dynamics. As such, we expect a bit more downside within the next 3–9 months, but timing remains challenging. We prefer for now to stay beta neutral (where risk is not correlated with broader market volatility) and seek relative value opportunities, remaining very selective in our high-yield risk exposure.

11/23

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