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Outlook

Fixed Income in Focus—Yield Potential Amid Narrow Spreads

With spreads at historic lows and yields at highs, fixed income markets present a rare dichotomy. Uncover insights and risks for 2025.

As we kick off the new year, fixed income markets present a mixed picture. Spreads across sectors are at their tightest levels since the global financial crisis (GFC), with investment-grade corporate spreads not this narrow since 1997. However, yields remain in the highest decile of cheapness post-GFC. This dichotomy is likely self-reinforcing as investors, drawn to elevated yields, accept lower spread compensation.

Yields and Spreads Are at a Dichotomy

 

Index Spread (bps) Rank (0=expensive, 100=cheapest) Yield (%) Rank (0=expensive, 100=cheapest)
Bloomberg US Aggregate Index 34 4 4.91 95
Bloomberg US Universal Index 58 1 5.13 93
Bloomberg Global Aggregate Index 35 7 3.68 92
Bloomberg US IG Corporate Index 80 0 5.33 88
Bloomberg Global High Yield Index 329 1 7.49 64
Past performance does not guarantee future results.
Source: Bloomberg as of 30 September 2024.

 

Drivers of Tight Spreads and Elevated Yields

  • Macro Factors: Investors remain optimistic about the U.S. economy’s growth trajectory, buoyed by the latest GDP data (3.1% quarter-over-quarter annualized), resilient nonfarm payroll growth, and continued strength in manufacturing. These factors have supported risk appetite.
  • Fundamental Factors: Corporate and consumer balance sheets remain strong. High-yield default rates, at just 1.1% (per JP Morgan), are well below the historical average of 3.4%. Consumer debt, relative to GDP, is at its healthiest level since the GFC.
  • Technical Factors: Fixed income markets have experienced robust inflows during 2024, with mutual fund inflows reaching a decade high of $425 billion. Additionally, net negative issuance in the high-yield corporate space in prior years has left the sector modestly smaller, contributing to a favorable supply-demand dynamic.

Despite these supportive conditions, historical patterns suggest caution. While there is little indication that a recession is imminent – if so, investors would price this risk into credit spreads immediately. We observe that the current environment resembles past environments where complacency was preceded by an unforeseen shock.

Rate Volatility Significantly Higher than Spread Volatility

Source: Bloomberg

 

Historical Lessons in Volatility and Complacency

A look back in history at the difference between rate and spread volatility (chart above) reveals that the current environment resembles other periods of complacency, such as 2005–2007 and 2018–2020, both of which preceded significant shocks to the global economy. During these times, tight spreads, combined with declining volatility, masked underlying risks that later emerged with substantial market dislocations.

In a similar vein, Barclays’ “Complacency Signal”—which tracks several market-based factors including high-yield realized volatility, high-yield and bank loan fund inflows, and the price of high-yield tail hedges—indicates that markets are at their highest level of complacency since September 2021. This signal underscores a growing risk that investors may not be adequately pricing the potential for disruption, particularly in credit-sensitive areas.

Investor Complacency Is at an All-Time High

Source: Barclays

Soft Landing: Historical Challenges and Modern Risks

The current pricing of risky assets reflects a market that has declared victory over recession. The Federal Reserve’s current communication suggests the risks to inflation and employment are roughly equal, which is a favorable place for the central bank to be. Rates that appear to be above neutral give the Fed the leverage it needs to keep inflation in check while having the ammunition to deliver cuts in the event that nonfarm payrolls trend lower.

However, history suggests that avoiding a recession after a rate-hiking cycle is the exception rather than the rule. Over the past 50 years, achieving a “soft landing” has typically required three conditions:

  1. No Shocks: Past shocks, such as oil price spikes, war, and the COVID-19 pandemic, have often derailed economic stability.
  2. No Financial Bubbles: Financial excesses, such as the dot-com bubble in 2001 and the housing bubble in 2008, have historically led to recessions.
  3. Good Politics: A combination of responsible fiscal policies and independent monetary policy is critical.

Achieving a Soft Landing Is… Hard

HIKING CYCLES GDP IMPACT
FED CHAIR END OF HIKING CYCLE DID RECESSION OCCUR? REAL GDP LESSON
Burns July 1974 YES -2.7% Inflationary Politics | Shock
Burns/Miller/Volcker April 1980 YES -2.2% Inflationary Politics
Volcker January 1981 YES -2.1% Inflationary Politics
Volcker August 1984 NO Positive No Shock | No Financial Bubble | Good Politics
Greenspan April 1989 YES -1.4% Shock
Greenspan April 1995 NO Positive No Shock | No Financial Bubble | Good Politics
Greenspan July 2000 YES -0.1% Financial Bubble
Greenspan/Bernanke June 2006 YES -3.8% Financial Bubble
Yellen/Powell December 2018 YES -10.1% Shock
Soucre: Bloomberg and Thornburg as of 30 September, 2024.

The mid-1980s and mid-1990s were rare periods when all three conditions aligned, enabling soft landings. Today, the risk of shocks remains unpredictable, but political/fiscal dynamics present a notable headwind. Addressing significant budget deficits could constrain growth, reducing the government’s contribution to economic expansion.

Final Thought

This outlook is designed to equip financial professionals and investors with the insights needed to navigate a challenging and evolving investment landscape.

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