Strong fundamentals, rich valuations.
That's our 2025 corporate bond outlook in a nutshell. Like the resilient economy, corporations generally remain strong as profits grow and cash balances rise. That's been a key driver of the outperformance so far this year, as falling credit spreads have pulled up corporate bond prices relative to Treasuries. All credit-related sectors have outperformed Treasuries year to date, with riskier, low-rated investments performing the best.
Riskier fixed income investments generally have outperformed this year
Source: Bloomberg. Total returns from 12/31/2023 through 11/29/2024.
Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Indexes representing the investment types are: Preferred Securities = ICE BofA Fixed Rate Preferred Securities Index; High-Yield Corporates = Bloomberg US Corporate High-Yield Bond Index; Corporate Floaters = Bloomberg US Floating Rate Notes Index; Investment Grade Corporates = Bloomberg US Corporate Bond Index; US Aggregate Index = Bloomberg US Aggregate Index; and US Treasuries = Bloomberg US Treasury Index. Past performance is no guarantee of future results.
That performance will be tough to replicate because spreads are so tight, but we still have a favorable view on corporate bond investments given the strong economic backdrop. With spreads tight, we are maintaining our "up in quality" bias, preferring investment-grade corporates for investors willing and able to take a little risk. Floating-rate corporate bonds appear attractive, as well.
Investors with long-term investing horizons can still consider preferred securities and high-yield bonds in moderation but we'd rather wait for higher relative yields before we suggest a potential overweight allocation.
In this outlook we'll discuss:
- The historically low level of credit spreads;
- The drivers of the low spreads;
- Why investing in corporate bonds can still make sense despite the low spreads.
Spreads are historically low
A credit spread is the extra yield that a corporate bond (or any non-government bond) offers over a comparable Treasury. It's meant to compensate for the added risk of lending to a corporation, like the risk of default (that is, the risk that a borrower will not make required payments).
When the economy is strong, spreads tend to be low. With a positive outlook, investors and lenders don't demand much risk compensation, because the perceived risk of default tends to be low. On the flip side, spreads tend to rise if the economic outlook deteriorates, as that can negatively impact corporate profitability and the ability to repay debt.
The average spread of the Bloomberg US Corporate Bond Index closed at just 78 basis points (or 0.78%) on November 29, 2024 and had actually touched 74 basis points in early November, its lowest spread since 1998.
Investment-grade corporate bond spreads
Source: Bloomberg, using weekly data as of 11/29/2024.
Chart reflects the Bloomberg US Corporate Bond Index. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
High-yield spreads recently touched new cyclical lows as well. The average spread of the Bloomberg US Corporate High-Yield Bond Index closed at 2.66% on November 29, 2024, and was as low as 2.53% in mid-November. That marked its lowest reading since May 2007.
High-yield corporate bond spreads
Source: Bloomberg, using weekly data as of 11/29/2024.
Chart reflects the Bloomberg US Corporate High-Yield Bond Index. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
The chart below illustrates how tight spreads are across all credit ratings1, not just the broad investment-grade and high-yield corporate bond indexes. Each diamond represents the percent rank of each spread—meaning how often the spread is as low or lower than its current level—over the past 20 years.
A reading of 2.0% for the broad high-yield bond index means that the spread is in the lowest 2% of all readings over the last 20 years. Put differently, spreads have been higher 98% of the time over the last 20 years. Average spreads for the AA through B indexes rank in the lowest 2.3% or less, highlighting how low corporate bond spreads are across the board.
These spreads are historically low and support our "up in quality" guidance. We think it makes sense to take risk if you're being compensated well, but that's not the case today with high-yield bonds. There's very little room for spreads to fall, which can limit the potential outperformance, but plenty of room for them to rise should the economic outlook deteriorate.
Spreads have rarely been this low over the past 20 years
Source: Bloomberg and the Schwab Center for Financial Research. Daily data from 11/29/2004 through 11/29/2024.
Indexes represented are the Bloomberg US Corporate Bond Index (IG), Bloomberg US Corporate High-Yield Bond Index (HY) and the credit rating sub-indexes of each respective index. Blue diamonds represent the percentile rank of the current option-adjusted spread of each index shown. A low percent rank means that the spreads are low relative to history, and vice versa. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Spreads are low for good reasons
The economy remains strong and corporations are making a lot of money: Pre-tax corporate profits, as reported by the Bureau of Economic Analysis, keep making record highs. At $3.8 trillion, profits are up 51% since the end of 2019. That is a high-level look at corporate profits, as it includes large, mid-size, and small companies, and isn't a look at a specific universe of corporate issuers, like investment-grade or high-yield only.
Not all companies are seeing this profit growth, of course, and certain issuers, specifically those with low ratings, could be struggling financially. But in the aggregate, corporations are making plenty of money to remain current on their debt obligations.
Corporate pre-tax profits declined modestly in the third quarter but remain near the all-time high
Source: Bloomberg, using quarterly data as of 3Q2024. US Corporate Profits With IVA and CCA Total SAAR (CPFTTOT Index).
Strong corporate fundamentals don't just include high profits. Corporate balance sheets are in good shape as well, with companies generally having plenty of liquid assets in both absolute terms and relative to their short-term liabilities. The rise in interest rates since the Federal Reserve began its rate-hike cycle in 2022 hasn't had the negative impact on corporate profitability that many may have expected, because many companies cleaned up their balance sheets and "termed out" their debt (that is, refinanced short-term debt into long-term) at rock-bottom rates in late 2020 and 2021.
The average coupon rate on corporate bonds has gradually increased from the 2022 lows, but they are close to the average borrowing costs from the years leading up the pandemic. Like current homeowners who locked in low mortgage rates and aren't necessarily affected by today's high mortgage rates, many corporations haven't yet felt the sting of high borrowing costs because they successfully refinanced a few years ago.
Case in point: The average coupon rate of the Bloomberg US Corporate High-Yield Bond Index is 6.4%, right where it was five years ago. For investment-grade corporate bonds, average coupon rates are slightly higher than the 2019 levels, but just barely.
Average corporate borrowing costs are generally in line with pre-pandemic levels
Source: Bloomberg, using weekly data as of 11/29/2024.
Chart reflects the Bloomberg US Corporate High-Yield Bond Index (LF98TRUU Index). Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Investors can still consider corporate bonds when spreads are this low
Spreads near record lows don't mean that they suddenly need to rise, which could pull corporate bond prices lower. If the economy remains strong, spreads may just stay at low levels. That means that the level of outperformance relative to Treasuries over the next six to 12 months probably won't be as strong as it was over the previous six to 12 months. But for a long-term investing standpoint, yields remain relatively attractive.
Here are four key considerations for investors considering corporate bond investments today:
1. Investment-grade corporate bonds continue to appear attractive. Corporate bond yields have risen alongside Treasury yields over the last few months. The average yield-to-worst (the lowest possible yield that an investor can earn on a bond with an early call provision) of the Bloomberg US Corporate Bond Index is back above 5%, closing at 5.1% on November 29, 2024.
The chart below takes a more granular look at average yields based on maturity and credit rating. The corporate bond yield curves are more upward-sloping than the Treasury yield curve, so investors can earn higher yields by considering intermediate-term bonds rather than very short-term investment alternatives.
Corporate bond yields vs. Treasury yields
Source: Bloomberg, as of 11/29/2024.
USD US Corporate A+, A, A- BVAL Yield Curve, USD US Corporate BBB+, BBB, BBB- BVAL Yield Curve, and the US Treasury Actives Curve. Past performance is no guarantee of future results. For illustrative purposes only.
Although we've adjusted our duration guidance and are now favoring a benchmark or below-average duration given the potential upside risk to bond yields, investors don't need to avoid intermediate-term bonds altogether.
From a strategic standpoint, corporate bond yields are still near the high end of their 15-year range. Investors looking for income and who have an intermediate- to long-term investing horizon should still consider investment grade corporate bonds given their average yields of 4.5% or more.
2. Investment-grade floaters may make sense as well. Investment-grade floating-rate notes, or "floaters," are a type of corporate bond whose coupon rate is composed of a short-term reference rate plus a spread. The reference rate can vary, but it's usually the Secured Overnight Financing Rate (SOFR)—a daily rate based on transactions in the Treasury repurchase market—which is highly correlated to the Federal Reserve's benchmark federal funds rate.
The Federal Reserve began cutting the federal funds rate in September 2024. Additional Federal Reserve rate cuts would pull coupon rates lower, but the shift in expectations for the number of rate cuts means that coupon rates might not fall much further.
Historically, fixed-rate corporate bonds have offered higher yields than floaters, but that shifted recently given the inverted yield curve. Now the average yields-to-worst of the Bloomberg US Floating Rate Notes Index and the Bloomberg US Corporate Intermediate-term Bond Index are very similar, with floaters currently offering a slight advantage.
Floaters currently offer slightly higher yields than fixed-rated intermediate-term corporates
Source: Bloomberg, using weekly data as of 11/29/2024.
Chart reflects the Bloomberg US Corporate Intermediate Bond Index and Bloomberg US Floating Rate Notes Index. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Floater prices are generally much more stable than fixed-rate corporate bonds. They can still fluctuate in the secondary market, and can decline if the economic outlook deteriorates, but their prices are much more sensitive to credit risk than interest rate risk.
Because floater coupon rates can adjust with market interest rates, their prices don't need to. While their coupon rates may fall a bit further from here, they can help protect investors should inflation prove stickier than expected, resulting in a higher fed funds "terminal rate," or if down the road the Fed needed to hike rates further.
3. Only consider high-yield bonds in moderation. High-yield bonds offer high absolute yields, with the average yield-to-worst of the Bloomberg US Corporate High-Yield Bond Index closing at 7.1% on November 29, 2024. It has been 7% or more since May 2022.
A large portion of that yield is due to the level of Treasury yields rather than risk compensation. Investors should be cognizant of the low spreads and what the downside might be should the economic outlook deteriorate. We maintain our neutral view and highlight that investors who hold high-yield bonds today should be prepared to ride out the ups and downs. For investors looking to be more tactical, there likely will be better entry points down the road should credit spreads increase.
4. Preferred securities can offer tax advantages, but relative yields have declined. Preferreds can still make sense from a strategic standpoint, but their yields have fallen sharply lately and don't provide much of a yield advantage relative to similarly rated investment-grade corporates.
Preferreds generally have offered higher yields than "Baa" rated corporates over the last few years, but today their average yields are very similar. With that yield advantage mostly gone, investment-grade corporates appear a bit more attractive than preferreds today.
Preferred securities don't offer much of a yield advantage over "Baa" rated corporate bonds
Bloomberg, using weekly data as of 11/29/2024.
Chart reflects the ICE BofA Fixed Rate Preferred Securities Index and Bloomberg US Corporate Baa Bond Index. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly.
Preferreds can offer tax advantages, however, which is why they may still make sense in a portfolio from a strategic standpoint. Many (but not all) preferreds make qualified dividend payments which may be taxed at lower rates than the ordinary income tax rates. When taxes are considered, preferreds can offer after-tax yields that are similar to, or even higher than, high-yield bond yields.
Although preferreds rank lower than traditional corporate bonds within a company's payment priority ranking, they tend to have higher credit ratings than high-yield bonds. Preferreds tend to be rated in the "Baa" and high "Ba" area, where high-yield bonds are all "Ba" and below.
Preferred securities can offer tax advantages
Source: Bloomberg, as of 11/29/2024.
Indexes represented are the Bloomberg US Corporate Bond Index (Investment Grade Corporates), Bloomberg US Corporate High-Yield Bond Index (High-Yield Corporates), and the ICE BofA Fixed Rate Preferred Securities Index (Preferred Securities). The after-tax column makes the following assumptions: Investment-grade corporate and high-yield corporates include a 37% federal tax, a 5% state tax, and the 3.8% net investment income tax (NIIT). Preferred securities assume a 20% qualified dividend tax and the 3.8% NIIT. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly.
What to consider now
We maintain a positive outlook on the corporate bond market given the resilient economy, but low relative yields prevent us from being more optimistic when it comes to taking additional risks. It often makes sense to take additional risks if you're being compensated well for those risks, but that's not the case today. We continue to find investment-grade corporates attractive given their yields near 4.5% or more, and investment-grade floaters can make sense as well.
We have a more neutral outlook on the riskier parts of the market like high-yield bonds and preferreds, but the strong economy can keep their prices supported for the near term. We'd consider those investments in moderation and would wait for higher relative yields for overweight positions.
1 The Moody's investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.
