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.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.Prepayment
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.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.
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More from Fixed Income Outlook
Download the Macro Report (PDF)Fixed income markets experienced widespread declines in the U.S. and globally in the third quarter of 2022, as inflation remained high and became more broad-based.