Credit: Solid in a slowdown?

Corporate bonds, in our view, continue to be an attractive proposition for investors. Over the last two years they have comfortably delivered a positive real yield (yield above inflation) in both investment grade (IG) corporate bonds (Figure 1a) and high yield (HY) corporate bonds (Figure 1b).

Many investors are drawn to corporate bonds because of the yield they offer. In accepting greater risk to capital, investors can gain access to yields above money market rates and those offered by developed market government bonds. We see this appeal continuing, particularly as the path for interest rates among leading central banks looks to be skewed to the downside.

Strong fundamentals

Of course, the yield on corporate bonds counts for little unless it is paid. Happily, defaults remain low and companies outside the lower credit ratings have, for the most part, managed to adapt to higher interest rates. Interest coverage (IC) ratios – which reflect earnings divided by annual interest payments – did fall initially as coupon interest rates reset higher during refinancing. This has begun to stabilise as central bank policy interest rates come down from peak levels and earnings have remained solid. Even at lower levels, current US corporate bond IC ratios are above average historically, emblematic of a generally better quality credit universe.

Up in quality preference

While many cohorts of credit have recovered since the Liberation Day shock (when President Trump announced sweeping tariffs) spreads on the US CCC-rated group remain notably wider at end May 2025 than they began 2025. These lower-rated high yield bonds tend to be more cyclical with higher debt levels. They are therefore more exposed to both a slowdown in the economy and interest rates lingering at higher levels.

In contrast, investment grade markets and BB rated high yield (BB is the higher quality end of the high yield spectrum) have broadly been on a round trip. Spreads (the additional yield a corporate bond pays over a government bond of similar maturity) initially widened (rose) on growth and inflation fears before narrowing (reducing) once the prospect for tariff de-escalation took hold. Current spread levels are quite tight, however, and are not pricing in any recession. For now, that assessment seems reasonable, as economic data is holding up. While still early days, consumers have not really changed their spending habits and companies appear reluctant to reduce headcount and potentially surrender market share to competitors when the outlook is still uncertain.

There are also geographical differences. With Germany embarking on a path of higher government outlay on infrastructure and Europe as a whole spending more on defence and encouraging reshoring (more localised manufacturing), new revenue opportunities are opening up for companies. Similar to China, we would expect Europe to pursue supportive action to mitigate the more punitive tariffs. By favouring higher quality companies, we think investors can maintain exposure to attractive yields without taking on too much credit risk.

Can high yield tolerate lower growth?

Regardless of the final outcome on tariffs, they are expected to raise costs and policy uncertainty is likely to weigh on confidence. Most economists have lowered their expectations for economic growth in the US. Back in March, the US Federal Reserve (Fed) revised down its forecast for US real gross domestic product (GDP) growth in 2025 to 1.7%, down from a forecast of 2.1 % back in December. It may lower it further at the Fed’s June meeting. High yield bonds typically prefer stronger growth since it often equates to higher earnings, stronger cash flow and, importantly, an amenable environment for issuing bonds as there is typically appetite from investors to take on credit risk. If we look back over the past four decades, on average (whether a mean or median) US high yield bonds have typically returned 1.4% in a quarter where GDP grew between 1%-2% annualised. Over a full year that would be approximately a 5.7% total return from high yield.

The differences in the chart between the average (mean) figures and median figures bear explanation. Being the middle figure of a set of numbers, the median strips out extremes to show the central observation. The average (mean) figure captures extremes. So, in quarters where there are sharp drops in GDP (<-3%), the mean figure of -3.3% for high yield returns reflects quarters in 2008 (Global Financial Crisis) and 2020 (COVID) when high yield bond prices fell sharply. Interestingly, shallower GDP falls equate to a positive return from high yield bonds at a mean level because this cohort captures quarters such as Q2 2009 where markets (correctly) took a reduction in the severity of economic decline to signal the worst was over. Bond prices rebounded in anticipation that the downturn was coming to an end.

Figure 3 shows that bond yields can respond noisily to changes in the economic outlook. Stronger corporate fundamentals, however, mean they may be less sensitive than in the past. Yield hungry investors are also likely to provide support to corporate bonds (at least among the higher credit ratings).

Taken together, we remain constructive on credit. A meaningful de-escalation in tariffs would likely see credit spreads tighten. On the other hand, they are already at fairly tight levels, so would be vulnerable to widening if sentiment shifted on bad news. We see advantages in remaining nimble by leaning towards higher quality companies that continue to offer exposure to attractive yields but offer less risk in any sell-off. Whatever the market environment, there are always pricing inefficiencies, but we think there may be better opportunities ahead to add to CCC rated bonds.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

There is no guarantee that past trends will continue or forecasts will be realised.