Which bond segment to choose in the current environment?
Bond market performance has been disappointing overall since January 1 (Figure 1). The resilience of the US economy and the slower-than-expected slowdown in inflation have led investors to fear that central banks may not be able to cut their policy rates as early as March. Market expectations now are that the Fed, but also the ECB, will ease monetary policy in June.
Given that investors are convinced that the bond yields will eventually fall, they are willing to take on more risk. Their primary objective is to take advantage of higher yields, knowing that those opportunities may no longer be available in a few quarters.
Graph 1: Year-to-date fixed-income returns
Bonds and the Fed
Currently, investors think the Fed will lower rates for the good reasons. That is, they believe they will do so because of a reduction of inflation and not necessarily because of an economic downturn. For this reason, the yield spread on U.S. high-yield corporate bonds (a benchmark commonly used to measure this perception of risk) fell to 351 basis points, its lowest level since January 2022.
This is even more impressive for investment-grade companies, as "single A" rated bonds now offer a premium of only 61 basis points, their lowest level in history. Normally, credit spreads are low when financial conditions are favorable and corporate defaults are minimal. Paradoxically, this is not the case today (Figure 2).
Figure 2: U.S. corporate yield spread: High yield (right scale) and Investment grade (left scale)
S&P 500 and spreads
This risk-taking in the bond market, which may seem reckless to some, has been aided by the strong performance of the stock markets, giving an impression of low economic risk. The S&P 500 has just reached a new all-time high of $5,137. With the exception of the COVID-19 period between 2020 and 2022, credit spreads have always moved in step with equity returns and volatility (Figure 3).
All three indicators react similarly to changes in economic and financial conditions. To keep U.S. spreads this low, the annual return of the S&P 500 will have to continue to exceed 15%. Otherwise, the possibility of seeing increased volatility and credit spreads is high.
Chart 3: High yield spreads (364 basis points) and inverted S&P 500 (31%)
What opportunities do we see?
In light of these expectations and given the current yield spread between High Yield and the rest, we believe it would be wise to avoid speculative bonds (Figure 4). Current speculative bond yields do not offset the potential risk of widening credit spreads ahead.
Chart 4: Current yields: US High Yield, US Investment Grade, US 10yr Treasury
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