U.S. credit spreads starting to reflect some risk, improving relative valuations

Key Takeaways

• In our most recent House Views update, we upgraded our 3- to 12-month outlook for U.S. credit by one notch, shifting investment grade (IG) corporates from “less attractive” to “neutral” and high yield (HY) corporates from “least attractive” to “less attractive.”
• The upgraded view follows credit spreads widening to their highest point since 2023, improving relative valuations in U.S. credit and offering more compelling starting yields that better compensate investors for the current economic landscape.

Wider credit spreads improve compensation for risks

Over the past year, credit spreads, (i.e., the difference between corporate bond yields and like-maturity U.S. Treasury yields) fell to historically low (or “tight”) levels. As IG and HY corporate credit spreads narrowed, these sectors’ relative yields became increasingly misaligned with the economic backdrop – namely, signs of decelerating growth, restrictive monetary policy, and tariff-induced uncertainty. This was particularly true in HY corporates (i.e., rated below investment grade), which are typically more sensitive to the state of the economy than their IG counterparts.

However, in both credit sectors, rich relative valuations insufficiently compensated investors for their additional credit risk. That narrative started to shift in mid-February as global trade disputes intensified and risk-averse trading gripped U.S. markets. IG and HY credit spreads widened to their highest levels since 2023. Over that span, the Bloomberg U.S. Corporate IG and HY indices underperformed the Bloomberg U.S. Treasury Index by roughly 2% and 5%, respectively. IG credit spreads (1.1%) are now just below their 10-year average, while HY credit spreads (4.3%) are trading roughly 0.2% above their 10-year average. In our view, the improvement in the relative valuations within U.S. credit now warrants an incrementally less negative outlook over a tactical horizon. However, we maintain our overall bias toward high quality fixed income, where yields remain elevated compared to the past 20 years and have provided valuable portfolio stability during the U.S. stock market’s latest struggles.

What we are watching

In April, absolute yields have risen sharply, which is important given that income is the primary driver of a bond’s total return. The IG and HY indices are currently yielding 5.4% and 8.6%, respectively. In the case of HY, that is the index’s highest yield since November 2023. Thus, these sectors’ higher starting yields improve their future return potential and provide some cushion if interest rates rise, spreads widen further, or defaults accelerate.

The relative valuations in IG and HY corporates do not yet warrant an overly aggressive allocation versus investors’ long-term investment targets. Current credit spreads do not fully reflect an economic slowdown and are far below recessionary-type levels. As noted in our Economic Commentary on April 7, we increased our probability of a U.S. recession to 50% within the next 12 months. Thus, these sectors remain susceptible to further underperformance in the event credit spreads widen in response to slower economic activity. Additional widening may create an opportunity to upgrade our IG and HY outlooks to more positive stances depending on their underlying fundamentals at that time. 

Bottom line

The recent spread widening and improved relative valuations in IG and HY corporates better compensate investors for these sectors’ risks and improve their future return outlook. However, U.S. credit spreads do not fully reflect a meaningful economic slowdown. While U.S. credit is beginning to price in some potential risks, the 50/50 odds of a recession over the next 12 months do not support an overweight position yet.