Corporate debt: Investment grade and high yield
Investment-grade bonds managed to recover from losses suffered in the first quarter to post positive performance. Within this environment, we have a positive outlook for the fundamentals and overall supply-and-demand backdrop underlying investment-grade corporate credit. Our view on valuation is more neutral, however, given the relative tightness of yield spreads as of quarter-end. Now that the U.S. economy has largely reopened, investors will have a keen eye on corporate earnings during the next few quarters. Market participants will also be watching for any shift in tone by the Fed, should inflation continue to move higher.
High yield rallied in June, along with stocks and Treasuries, amid growing confidence that inflation will likely prove transitory. Relative to other asset classes, high-yield bonds outpaced high-yield bank loans and the broad investment-grade (IG) fixed-income market, but modestly lagged IG corporate credit. We have a positive outlook for high-yield market fundamentals and the overall supply-and-demand backdrop. Our view on valuation is more neutral, given the relative tightness of yield spreads in the market as of quarter-end. Our optimism is grounded in the rapidly growing percentage of Americans receiving Covid-19 vaccines, sustained government stimulus, and the continuing recovery of the U.S. economy. That said, we continue to closely monitor issuers' balance sheets and liquidity metrics, with an eye toward default risk or a credit-rating downgrade. Risks to our generally constructive outlook include any new developments with Covid-19, volatility in commodity prices, and policy missteps from global central banks. Expectations for defaults have meaningfully improved this year, given the liquidity in the market.
Trends in the mortgage market
In the commercial mortgage-backed securities (CMBS) market, we believe there are attractive risk-adjusted investment opportunities available amid an improving fundamental backdrop. In our view, borrowers with access to capital will continue to make investments in properties that were performing well before the pandemic hampered their revenue streams.
Near-term inflation expectations are significantly higher than they were prior to the pandemic. We think commercial properties can better absorb inflation pressures compared with other market sectors, such as corporate credit. Consequently, if inflation rises, we believe areas of the CMBS market may offer compelling relative-value opportunities.
Within residential mortgage credit, given low mortgage rates, high demand, and a declining inventory of available homes, we think home prices are likely to continue rising. Even with tighter spreads, we have continued to find opportunities in investment-grade securities backed by non-agency residential loans, along with legacy residential mortgage-backed securities and lower-quality segments of the agency credit-risk transfer market.
We believe prepayment-sensitive areas of the market serve as important sources of diversification. To us, the prepayment sector offers potential benefits in the event of an economic slowdown, changes in fiscal policy, and/or rising interest rates. In our view, many prepayment-sensitive investments offer attractive risk-adjusted return potential at current price levels. In terms of investment selection, we are focused on securities backed by reverse mortgages, jumbo loans, and more seasoned collateral.
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Global financial markets were mixed during the second quarter.