Bonds with credit risk may outperform government debt
Fixed Income Outlook
Head of Global High Yield and Chief Investment Officer, Fixed Income
Head of International Fixed Income
Already this year, two events have occurred that have broken historical precedent and shifted the global fixed income landscape. The massive German fiscal expansion and the Trump administration’s tariffs have resulted in a weaker outlook for developed market sovereign bonds and a stronger one for credit and some emerging markets. More recently, rising anxiety over the US’s fiscal position led to a sell‑off in US Treasuries.
The combination of recent events has triggered a global regime change. One of the most conspicuous symptoms of this is that above‑target inflation in some developed markets looks here to stay. The inflation outlook is particularly downbeat for the US, where we expect the tariff‑induced supply shock to produce a material bump higher in prices despite lower oil prices offsetting some of the upward pressure in the short term. With inflation currently running at an elevated 2.5%–3.0%, it is difficult to see it reaching the Federal Reserve’s 2% target over the next few years.
The likelihood of a global recession—with the US leading the downturn—has also increased. Even if President Trump lowers tariffs from their current levels or abandons them entirely, there will be lingering damage as the uncertainty of the on‑again, off‑again trade levies at varying levels have damaged corporate and consumer confidence. Instead of a traditional recession, what may transpire—especially in the US—is a longer period of subpar growth with both higher unemployment and higher inflation.
The mix of structurally higher inflation and the higher probability of a steep downturn in growth means that the Fed’s monetary policy is essentially on hold for the time being. Outside the US, where inflationary pressure is somewhat lower, other developed market central banks have more room to lower rates.
In the short term, we expect continued volatility as fixed income markets work through the implications of regime change. Over the longer term, European growth, driven by Germany’s aggressive fiscal expansion, should recover relatively quickly. Global inflation is likely to push higher amid supply problems stemming from the trade war. We expect to see higher yields as investors anticipate the erosion of developed market sovereign bond values by inflation.
“This outlook does not bode well for high-quality global sovereigns...”
This outlook does not bode well for high‑quality global sovereigns over the long term. However, the picture is a little different for fixed income sectors with credit risk. As of late May, credit spreads2 have narrowed to near‑record lows after the sell‑off in April’s turbulence, so they could certainly widen further in the near term. However, corporate bond markets—both investment grade and high yield—are going into this economic downturn with meaningfully higher overall credit quality than in the past.
One‑third of the non‑investment‑grade bond market is secured,3or backed by collateral that goes to the bondholder in the event of default. In another indication of higher credit quality and recession resistance, the amount of non‑energy cyclical sector exposure in the Bloomberg US High Yield 2% Issuer Cap Index was about eight percentage points lower as of March 31, 2025, than 10 years earlier. From a broader point of view, the average credit rating of the non‑investment‑grade index was higher as of the end of March than it was 10 years ago.
That said, some of the weaker high yield issuers in sectors dependent on consumer spending could default as tariffs slash their profit margins. Prior to the early April tariff announcements, our high yield credit analyst team anticipated a 2025 US default rate of about 5%.4 We now think it could drift higher but doubt that it will reach the 7%–8% level experienced following the onset of the pandemic in 2020.
Shorter‑maturity investment‑grade corporate bonds should hold up better than longer‑maturity corporates in an environment of increasing long‑term government yields. In the high yield market, shorter‑maturity bonds with early refinancings ahead of maturity dates are also potentially attractive.
Within the non‑investment‑grade market, we modestly favour bonds over bank loans because loans are generally trading at higher prices currently, giving them less price appreciation potential. Also, loans—which have floating rate coupons that adjust in lockstep with short‑term interest rates—are exposed to spreads widening in a recession at the same time that coupons are dropping if the Fed is forced to cut rates.
In international markets, bonds from emerging markets that are less exposed to the tariff war—particularly those in Latin America and Eastern Europe—could hold up surprisingly well, providing attractive opportunities for yield and diversification. Another advantage of emerging market exposure is that some higher‑quality emerging market sovereigns have been less volatile than developed market government bonds, including US Treasuries.
2 Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar‑maturity, high‑quality government security. 3 Source: J.P. Morgan. 4 Default estimate includes both traditional defaults and distressed exchanges. If a distressed exchange is deemed likely for an issuer, we consider all the securities of that issuer within the index to be in default. Actual outcomes may differ materially from estimates.
Corporate bonds are entering a likely economic downturn with historically high credit quality, positioning them more defensively than in the past.
Paul Massaro, CFA®, Head of Global High Yield and Chief Investment Officer, emphasises that the two key factors driving global bond markets this year are the United States' tariff actions and the significant German fiscal expansion.
