Corporate credit shows resilience
Our more cautious view rests on a positive outlook for market fundamentals and our belief that valuations have improved for both investment-grade and high-yield credit. However, market technicals remain challenging, and while corporate fundamentals remain solid overall, they will likely weaken in the face of slower growth and margin pressure, in our view. High inflation, central bank tightening, and the impact of geopolitical developments on energy supplies remain considerable headwinds for both fundamentals and the market's technical backdrop.
Floating-rate bank loans may outperform
We have a moderately positive outlook for the floating-rate loan market. However, given tightening monetary policy, the ongoing war in Ukraine, and lingering supply chain disruptions due to Covid-19, we anticipate continued bouts of volatility. As we assess the impact of these and other factors on the companies in our investment universe at the beginning of the fourth quarter, the majority of loan issuers have sufficient capital to absorb the pressure that higher interest rates place on free cash flow.
Sector performance varied as corporates outperformed mortgage-backed securities
Source: Bloomberg, as of 9/30/22. 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. EMD (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).
* Excess returns are calculated relative to comparable-maturity U.S. Treasuries for each index. Excess return does not always mean "outperformance."
Cautious optimism for structured credit
Consistent with risk markets generally, CMBS spreads have widened during 2022. From our perspective, the increased liquidity premium has enhanced the appeal of select market segments.
Commercial mortgage credit
We believe the fundamental environment for the commercial real estate market will be mixed. While travel, office use, and retail spending have rebounded, we believe current Fed policy will likely result in a recession. Broadly speaking, property categories that can effectively pass along higher costs, such as hotels and apartments, will maintain their value, in our view. At the same time, we think property types with longer leases and exposure to rising capital costs and/or in need of capital investment will face pressure to refinance loans.
Residential mortgage credit
We believe U.S. homeowner balance sheets remain strong. Looking ahead, we expect home prices are likely to decline in 2023 and experience tepid growth during the next few years. Affordability constraints for many buyers and a gradual increase in housing supply will slow price appreciation. 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 among seasoned collateral that we believe can withstand declining home prices due to significant built-up home equity.
In light of last year's repricing of the sector, we are finding what we consider to be compelling investment opportunities across a variety of collateral types as 2022 has brought renewed optimism to this market. Mortgage rates have spiked above 6% for the first time since 2008, affordability pressures are dampening housing activity, and mortgage originators are trimming staff and shifting focus to alternative loan products. A scenario of a slowing housing market, falling home prices, and/or capacity or underwriting constraints could further dampen prepayments and fundamentally benefit the sector. 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 continue to slow, which we believe is likely.
Tax-exempt bonds look more promising
Municipal bonds are coming off a difficult three quarters. Negative returns, market volatility, and weak technicals contributed to record municipal bond fund outflows. However, while we are still cautious, we believe credit fundamentals are strong and valuations are attractive. The increased income from higher yields can help provide a cushion against negative returns and rising interest rates, in our view. Future returns look more promising for longer-term investors, in our opinion.
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