We have a cautious outlook on U.S. corporate credit and expect volatility to remain elevated. Macro forces of bank-related volatility, high inflation, central bank tightening, slowing growth, and geopolitical impacts on energy remain considerable headwinds for both fundamentals and market technicals. However, in our view, we are likely nearing a point where the interest-rate hiking cycle will start to wind down, especially given the recent bank turmoil.
We believe corporate fundamentals have likely peaked for this cycle, as higher rates and slower growth weigh on financial conditions, but remain resilient. Market technicals have been improving, although we expect them to remain tethered to investors’ risk appetite in the near term. Credit spreads are not reflective of potentially recessionary conditions in the future, in our view, but high yields and low dollar prices provide valuation support. Risks to our outlook include further volatility in the banking industry, policy missteps from global central banks, a more severe slowdown or recession, and heightened geopolitical tension.
Floating-rate bank loans
We expect loan price dispersion to remain high, thereby creating more opportunities for outperformance given our active, credit-driven strategy. We believe the U.S. leveraged loan market may be at, or very close to, a price dispersion inflection point, when loan prices will begin a sustained recovery. We expect the U.S. leveraged loan market to generate returns in 2023 that are above their long-term annual average. With that said, most non-investment-grade issuers continue to be challenged by inflationary pricing and a more discerning consumer, which has squeezed profit margins. Higher interest rates are also creating lower interest coverage ratios for those borrowers that hadn’t hedged their floating-rate liabilities, and we expect defaults to gradually increase to the 3.0%–3.5% range over the next 12 months. In this environment, prudent credit selection will likely be an important driver of alpha.
Figure 2. Excess returns were mixed across risk assets in Q1
* 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 3/31/23. 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).
Commercial mortgage credit
We believe overall fundamentals for commercial real estate will be mixed. Recent turmoil in the regional banking sector and negative headlines surrounding office properties have added to concerns about the CRE market, with borrowers facing the rising cost of capital and a tighter credit channel. But we believe these additional risks combined with a heightened risk of recession are largely priced into the market. As such, current spread levels offer strong opportunities for security selection, in our view.
Residential mortgage credit
We expect home prices will decline in 2023 and that this will be followed by tepid growth in subsequent years, as affordability continues to constrain demand and supply gradually increases. Given our macroeconomic and housing outlook, we favor bonds higher in the capital stack with shorter spread duration as well as bonds with seasoned collateral that can withstand home price declines. (The capital stack is the structure of debt and equity, and it defines ownership rights, and their order of priority, for income and profits.) Residential mortgage credit spreads have widened significantly across the capital stack over the past year, creating very attractive risk-adjusted return opportunities.
We expect prepayment speeds will be stable going forward, and that the sector provides good protection against any future recession scenario that negatively impacts home prices and/or unemployment. 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. Certain subsectors offer the potential for additional upside if prepay speeds can slow further.
We are now neutral to the mortgage basis, mostly due to uncertainty related to bank demand and the possibility that the FDIC may sell its mortgage holdings. (Mortgage basis is a strategy that seeks to exploit the yield differential between current-coupon, 30-year agency pass-throughs and 30-year U.S. Treasuries.) We believe this year will require us to remain tactical and actively trade the basis as new information emerges and events occur.
Municipal credit fundamentals continue to be stable, in our view. Higher employment and increasing wages have bolstered tax receipts. Home values, a factor in property tax revenues, are beginning to face headwinds in the form of higher mortgage rates and lower affordability. State and local government reserves are near record highs and should aid municipalities as tax revenues decline into an economic slowdown.
Municipal defaults are running below long-term averages as of March 31, 2023, and they remain a very small percentage of the market. We continue to have a positive view on investment-grade municipals as we approach the end of the Fed hiking cycle.
Emerging market credit
We remain cautious on our intermediate outlook in emerging markets (EM). We are currently focused on growth, with a U.S. recession and a slowdown in global growth likely, neither of which has been fully priced into the market. It is a growing concern, reflected primarily in high-yield spreads, which have moved wider, but EM investment-grade spreads remain well within recessionary levels. Therefore, we expect a bit more downside within the next 3–9 months, although timing is a challenge. We prefer to stay beta neutral, for now, and seek relative value opportunities, remaining very selective on our high-yield risk exposure.
This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon as research or investment advice regarding any strategy or security in particular.
This material is prepared for use by institutional investors and investment professionals and is provided for limited purposes. This material is a general communication being provided for informational and educational purposes only. It is not designed to be investment advice or a recommendation of any specific investment product, strategy, or decision, and is not intended to suggest taking or refraining from any course of action. The opinions expressed in this material represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor's particular investment objectives, strategies, tax status, or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the material. Predictions, opinions, and other information contained in this material are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss.
This material or any portion hereof may not be reprinted, sold, or redistributed in whole or in part without the express written consent of Putnam Investments. The information provided relates to Putnam Investments and its affiliates, which include The Putnam Advisory Company, LLC and Putnam Investments Limited®.
BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approve or endorse this material, or guarantee the accuracy or completeness of any information herein, or make any warranty, express or implied, as to the results to be obtained therefrom, and to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.