We have a cautious outlook on U.S. corporate credit, with an expectation for elevated volatility. Macro forces of high inflation, central bank tightening, slowing growth, and geopolitical impacts on energy remain considerable headwinds to both fundamentals and market technicals (supply/demand metrics), though we are likely nearing a point in the coming months where the hiking cycle will start to wind down.
Corporate fundamentals, while strong, have likely peaked for this cycle as higher rates and slower growth weigh on financial conditions. Technicals have improved as flows have moderated in recent months. Lower new issuance in 2022, coupled with record volume of rising stars, creates a somewhat supportive technical backdrop. Valuations are somewhat more attractive than this time last year, and credit spreads are not reflective of potentially recessionary conditions in the future.
Risks to our outlook include policy missteps from global central banks, a more severe slowdown or recession, ongoing supply chain disruptions, commodity price volatility, heightened geopolitical tension, and/or surges in Covid cases.
Floating-rate bank loans may outperform
Corporate fundamentals, generally speaking, have persisted, but most non-investment-grade issuers remain challenged to maintain or recover margins impacted by inflation and a much more discerning consumer. While we expect default rates to gradually increase throughout 2023, loan market prices can actually move higher in such scenarios, and they have historically done so. Prudent credit selection will continue to be paramount for generating alpha.
Our team did a recent analysis of the three most significant periods of volatility in the U.S. leveraged loan market over the last 15 years: the global financial crisis (2008–2009), the energy sector sell-off (2015–2016), and the Covid-19 pandemic (2020). It showed loan market volatility as measured by price dispersion (the difference between the worst and best performers) is highly correlated with the level and the change of returns rather than default rates. Loan price dispersion hit 13% at the end of 2022 — its highest reading since the onset of the pandemic in Q2 2020. Yet there were no defaults in Q4 2022, and the number of loan gainers outnumbered decliners in the quarter. We believe the U.S. leveraged loan market may be at, or very close to, a price dispersion inflection point and poised for attractive returns in 2023.
Excess returns in risk assets turned mostly positive
*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 12/31/22. 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. Mortgage Backed Securities Index, which covers agency mortgage-backed pass-through securities (both fixed rate and hybrid ARM) issued by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
Macro-driven volatility pushed spreads wider across the sector in 2022 despite continued fundamental improvements, creating strong opportunities for security selection. We expect greater return dispersion across the market in the near term, which increases the importance of rigorous loan-level analysis to uncover relative value. We currently favor shorter spread duration assets, namely seasoned mezzanine tranches on deals with high-quality collateral, which offer very attractive relative value and should be insulated from losses even in recessionary scenarios, in our view. Overall, we believe structured credit currently offers both diversification benefits and attractive relative value to corporate debt.
Commercial mortgage credit
Our outlook for commercial real estate is mixed. We expect fundamentals to improve as more people return to travel, offices, and retail stores. This view is tempered by the Fed's hawkish interest-rate policy, which could cause a recession. We believe those property types that can pass along inflation costs, such as hotels and apartments, will hold their value and perform well in this environment. On the other hand, property types that have longer leases, rising capital costs, or require large capital improvements will come under pressure. We continue to favor seasoned mezzanine tranches on high-quality deals that offer attractive relative value and are insulated from losses or a recession, in our view.
Residential mortgage credit
We expect home prices to decline modestly in 2023 and to grow more slowly thereafter. After sharply rising during the pandemic, home price appreciation is slowing due to affordability constraints for many buyers and a gradual increase in supply. Within residential mortgage credit, wider spreads have created better value across all credit tiers. We are finding attractive investment opportunities in higher-quality areas of the market, as well as seasoned collateral that can withstand declining home prices.
We believe many prepayment-sensitive securities offer attractive risk-adjusted returns at current price levels and prepayment speeds. Many of these securities may also offer meaningful upside potential if mortgage prepayment speeds slow further, which we believe is likely. We also find value in the mortgage basis, which is now historically wide, but we are maintaining a cautious position amid heightened interest-rate volatility. Given last year's repricing of the sector, we are finding what we believe are compelling investment opportunities across a variety of collateral types.
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 facing headwinds in the form of rising mortgage rates. We believe assessed values, another factor in taxes, should continue to reflect growth given the roughly two-year lag between tax assessments and actual property values. Market technicals improved during the fourth quarter. New-issue supply was very light, aiding returns. At the same time, demand rebounded amid the improvement in investor sentiment.
Emerging market credit
Within emerging market credit, we expect global economic conditions to be challenging, but some valuations and countries appear to be attractive. China's reopening near quarter-end has been a positive development. We continue to look for opportunities in countries that are less exposed to geopolitical turmoil as well as to global and domestic policy risks.
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