Key takeaways

  • After an unprecedented year in 2022, value has finally returned to the bond market in 2023. A number of factors will provide fixed income investors with an attractive opportunity, including improvement in yields, favorable spread levels in credit sectors, and duration transitioning from a headwind to a tailwind.

  • Improving inflation, a Fed pause, and recession fears suggest that duration should work in investors’ favor in the near-term.

  • If a recession is to materialize by the second half of 2023, there will be more attractive entry points to add credit spread exposure to a multi-sector fixed income portfolio. We favor U.S. long duration and short credit spreads and recommend adding credit risk when it appropriately prices the looming recession.

2022 was a year for the record books in U.S. fixed income markets. The Bloomberg U.S. Aggregate Bond Index (“the Agg”) celebrates its 50th anniversary in 2023. In those 50 years, 2022’s calendar year total return of -13.01% was unprecedented. The prior record was 1994 (-2.92%); in fact, the cumulative total return of the previous four negative years (1994, 1999, 2013, and 2021) was only -7.30%.

Bloomberg U.S. Aggregate Bond Index yearly returns

Bar graph of U.S. aggregate bond index yearly returns from 1980-2022

Source: Bloomberg. As of December 2022.

With pain comes opportunity, and we believe that the current landscape offers a compelling entry point for fixed income investors. At the start of 2023, the yield-to-worst on the Agg stood at +4.68%, the highest level since 2007. As recently as the beginning of 2020, the Agg yield-to-worst was a paltry +1.12%; in other words, value has finally returned to the bond market.

We believe a number of factors will provide fixed income investors with an attractive opportunity, including an improvement in yields relative to recent history; forthcoming favorable spread levels in credit sectors (anticipated at some point in 2023); and duration transitioning from a headwind to a tailwind. Regarding duration, we believe the fundamental outlook is far more promising than the past few years. Unpacking that view, we focus on three key items:

1. Inflation data improves

In terms of inflation in the U.S., prices are now declining across major goods categories, including used autos, apparel, and furnishings. Consumer Price Index (CPI) core goods over the past three months have averaged -4.8% (annualized), which has been the primary driver of the recent improvement in inflation.

Core services inflation, on the other hand, remains “sticky” and well above the Fed’s +2% target, running +6.1% (annualized) over the past three months. Digging deeper, we see substantial progress in core services ex-shelter, which averaged +8.6% (annualized) in the first half of 2022 but only +4.0% in the second half and has continued to trend lower in recent months. CPI owners’ equivalent rent (OER) has yet to show signs of significant improvement, averaging +8.6% (annualized) over the past three months, just off of the cycle’s peak. OER tends to be a heavily lagging measure, partly because the vast majority of leases are twelve-month leases, while it takes a full year for the rental cycle to fully reflect current home prices (which in turn lag changes in interest rates). As the Cleveland Fed noted, “Rent inflation for new tenants leads the official Bureau of Labor Statistics (BLS) rent inflation index by four quarters”.1

Such timely measures of new lease signings, such as the Zillow and Apartment List indices, peaked more than a year ago and have posted sharp declines recently—certainly a good sign that official measures are soon to follow. After a record +17.6% in 2021, Apartment List’s rent index cooled to +3.8% in 2022, about in line with pre-pandemic levels. Each of the past four months has been negative.

2. Fed nears the finish line

While the nascent improvement in inflation is a welcome development for the Federal Reserve (Fed), the labor market remains strong by most measures. Additionally, the Fed is still reeling from credibility issues after erroneously expecting a transitory spike. Therefore, as the December Federal Open Market Committee Minutes state, “Participants continued to anticipate that ongoing increases in the target range for the federal funds rate would be appropriate to achieve the Committee’s objectives.” However, they also recognize a risk, “that the lagged cumulative effect of policy tightening could end up being more restrictive than is necessary to bring down inflation to 2% and lead to an unnecessary reduction in economic activity, potentially placing the largest burdens on the most vulnerable groups of the population.” While additional hikes are likely, we think that continued progress on inflation and slowing economic data should allow the Fed to pause in the first half of 2023.

3. Probability of recession grows

The current cycle of Fed/global central bank tightening has been much more aggressive than recent cycles. The steady 25 basis point per meeting stair step function gave way to 75 basis point hikes. Historically, it is unusual for the Fed to continue hiking as the manufacturing sector enters a period of contraction, but that is exactly what has been happening. The following graph shows ISM manufacturing new orders versus the Federal Funds rate, with the terminal hike highlighted for each cycle. New orders have declined substantially and are now below the 50-diffusion line, consistent with a contraction. Historically that has occurred after the Fed has been on pause, but this time new orders are already contracting and trending even lower as the Fed continues to hike.

ISM new orders vs. federal funds rate

Time series chart of ISM new orders vs. the federal funds rate from 1980-2022

Source: Bloomberg. As of December 31, 2022. Indices represented are NAPMNEWO Index: ISM Manufacturing Report on Business New Orders SA Index; FDTR Index: Fed Funds Target Rate U.S. Index.

Additionally, quantitative tightening has continued at a pace roughly double that of prior balance sheet reductions and banks are finally tightening lending standards. The impact is readily apparent in interest rate sectors, such as housing and auto sales. Global manufacturing indices are signaling that a contraction is already underway, while most leading recession indicators are signaling that a contraction is likely in the latter portion of 2023.

What this means for fixed income investors

Improving inflation, a Fed pause, and recession fears suggest that duration should work in investors’ favor in the near-term.

In addition to being constructive on duration, we believe that the opportunity for credit spread product will arrive in 2023 as well. Credit spreads widened in 2022 as the Fed removed stimulus; however, recently the markets have been in “bad news is good news” mode and spreads have tightened back somewhat, even as the global economy slows. The thinking is that bad economic data will cause the Fed to pause and eventually pivot to lower rates. We think that mentality is premature unless the Fed can engineer a soft landing, which we view as very unlikely. High-yield credit spreads are currently nowhere near prior recessions or even periods of low-risk sentiment, such as the 2011 European sovereign crisis or the 2015 energy volatility.

U.S. high yield option-adjusted spread

Time series chart of U.S. high yield option-adjusted spread from 1999-2022

Source: Bloomberg. As of January 2023. Index represented is Bloomberg U.S. Corporate High Yield Index.

History shows that if a recession is to materialize by the second half of 2023, there will be more attractive entry points to add credit spread exposure to a multi-sector fixed income portfolio. Current spread levels are more consistent with a soft landing than a recession, and the recent rebound in spreads has been partly due to technicals (flows returning to fixed income and light new issuance in high yield), improving inflation data, and an anticipated end of Fed hiking cycle on the horizon.

Given this outlook, we are favoring U.S. long duration and short credit spreads and will look to add credit risk when it appropriately prices the looming recession. After a historically painful 2022 in multi- sector fixed income, 2023 looks to be a year of great opportunity.

Principal Fixed Income: A leading global fixed income platform

Principal Fixed Income is the fixed income investment management platform of Principal Asset Management and manages $133.9 billion in assets under management as of December 31, 2022. Importantly, we have capabilities that span all major fixed income sectors. Our globally integrated platform, with eight investment centers worldwide and over 110 investment professionals, helps to directly access global fixed income markets and deliver a diversity of investment perspectives. Our structure and proprietary investment tools foster cross-sector collaboration across sector-specialty teams, whether the sector is explicitly integrated into a portfolio or not. In our view, this diversity of insight helps each sector-specialty team formulate richer investment theses and make better-informed investment decisions on behalf of our clients.

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