Fortune Favors the Disciplined: The Margin for Error Remains Low

Over the last three years, the compensation bondholders receive for taking credit risk has persistently declined. This seems largely due to some investors’ focus on absolute nominal yields, which are indeed higher than we’ve seen for much of the last 20 years. But with bonds, where downside is asymmetrically skewed compared to the upside, disciplined considerations of risk should always be in fashion. In these summer fixed income observations, we explore:

• Dissonance between fundamental indicators and market prices
• The relationship between inflation and “risk-free” interest rates
• Default risks and credit spreads
• Prospective bond price volatility if there is movement in credit spreads

Overall, we find that:

1. After a couple years of notably benign credit losses, fixed income markets seem to be pricing in expectations that the good times will never end. History indicates that cycles do turn, and that it’s always important for bond investors to price in future risks—not the recent tranquility.
2. The “risk-free” yield curve now compensates investors for duration after many years when a flat yield curve meant investors’ main compensation came from taking credit risk. This has changed the opportunity set for building a bond portfolio to generate attractive income without taking unnecessary volatility or credit risk over a cycle.
3. Recent credit spread compression has protected portfolios with high exposure to lower grade bonds from the headwinds typically experienced when interest rates rise, but a return to normal credit spreads or default rates could be a future challenge for for returns from lower quality bonds.
4. For higher earners with taxable investment accounts, the tax-equivalent yields available from municipal bonds still offer attractive relative value.

Fortune Favors the Bold(?)

“Fortune favors the bold” has been a motivational quote for 2,000 years, attributed to the Roman figures Turnus and Pliny the Elder. The catchy saying is used to encourage risk taking, with the idea that “of course” the rewards will far outweigh the downside. But we must also remember that after making their riveting speeches, both Turnus and Pliny the Elder actually died on their expeditions. Unfortunately, sometimes caution is warranted.

In every bull market, risk-taking is rewarded for long enough that many people become sure that being bold is the key determinant for good returns. And while bond investors are stereotyped as restrained and cautious, bond markets are not exempt from the “irrational exuberance” once popularized by Alan Greenspan.

Over the last three years, there has been almost no downside for leaning into risk in fixed income markets. Default rates have remained subdued, and credit spreads have compressed. Despite inflationary pressures and geopolitical turmoil, investors have demonstrated a remarkably sanguine reaction to a variety of rising external risks.

We do not believe the sky is falling, but we do believe that the laws of gravity (and the business cycle) still apply, even if underlying stress has recently been offset by the low pre-2022 borrowing rates, light bond covenants, and easier access to additional capital for strained borrowers.

Bond markets normalized in 1994 after the first Gulf War, and the bondholder experience since then covers the long arc of technological disruption, financial innovation, geopolitical re-ordering, policy changes and demographic dynamism, along with multiple economic booms and busts. These last three decades, for which we also have more comprehensive data than in earlier years, provide good context for assessing the current environment.

Bonds issued in 2023-2025 have seen lower-than-typical defaults, and the overall annual default rate has also recently been below average. We can understand why those who have been bold feel good.

But history says that it’s still appropriate to expect bumps in the road ahead. We have seen that across the investment grade and high yield credit spectrum, defaults and other credit risks never disappear. This is an environment where patience and discipline are essential.

Cumulative Default Rates (1994-2025, issuer-weighted)

Dissonance Between Current Fundamentals and Market Prices

Although there are many reasons to consider the fundamental risks for borrowers across the world, for brevity, we will focus on U.S. conditions since U.S. fixed income is generally the baseline cost of capital for global investors.

We entered 2026 expecting uncertainty. The year began with a continuation of tariff uncertainty, which reached a new inflection point with the Supreme Court ruling in February. Then, just eight days later, the United States and Israel launched coordinated air and naval strikes inside Iran, a situation that appears to be moving more toward stalemate than resolution. We also have a new Fed chair in Kevin Warsh and more policy questions than at any time in recent years. It now seems likely that global ambiguity and unpredictability will carry into 2027.

We also observe incremental stress for many businesses and consumers, yet fixed income markets remain surprisingly calm. New issue supply has been absorbed without pause, and (as we’ll repeat frequently) the compensation bondholders receive for taking risk is near historic lows across the credit quality spectrum.

This is a notably different environment than we experienced in 2022 following the massive repricing of global interest rates and the uncertainty that followed Russia’s invasion of Ukraine, or even the period immediately after ‘Liberation Day’ in 2025. In the charts above, we see the above-average default rates for 2021-2022 issuance as stresses flowed through to fundamentals. Consequently, bond markets moved quickly to price the higher risk potential in 2022.

But in 2026, following a couple of years with benign default rates, investors haven’t required higher credit spreads (both the Ukraine and Iran conflicts began at the end of February, and Liberation Day was at the beginning of April, providing a clear like-for-like calendar comparison).

Corporate Bond Credit Spreads Don’t Reflect Potential Stress

Yet, in the left chart below, we see that:

• Delinquency rates have steadily risen for all types of U.S. consumer borrowing, and bankruptcy filings have also been rising for several years.
• The rate of businesses declaring bankruptcy is back above pre-COVID levels, and consumer bankruptcy filings have clearly bounced off the stimulus-supported bottom, even if they haven’t yet returned to the 2019 level.

We are not saying it is the worst of times, but it is certainly no longer the best of times either. Yet as these indicators of stress have risen, the compensation for taking risk has fallen. The right chart illustrates the dissonance between these risk indicators and what the fixed income markets are pricing:

• The Economic Policy Uncertainty Index has moved notably higher over the last 18 months. It remains near its peak level during COVID.
• Historically, credit spreads have typically widened when the uncertainty index rose, this time we have actually seen credit spreads tightening.

Many other economic and business health indicators are also signaling that risks are stable at best. We haven’t even broached the uncertainty about disruption risks from artificial intelligence, because the fixed income market environment is so decidedly “risk-on.” Risk-on markets mean investors must be laser-focused on security-specific opportunities to identify relative value across rating categories and asset classes, and along the yield curve.

Today, we are broadly cautious about the risk-reward construct for lower credit quality securities, but we would note that investors can now take a moderate amount of duration and credit risk and still receive a compelling risk-adjusted return. The yield curve is now steeper than it has been for two decades, and Treasurys and investment grade bonds are yielding more than most of the high yield category did just five years ago.

We understand the natural temptation for investors to want to stretch for a few extra basis points of yield from more speculative bonds. However, in a world with many unquantifiable and unpredictable risks, we generally see sufficient compensation along the entire higher quality yield curve, allowing investors to be patient about increasing risk until credit spreads return to more normal levels,

For many people’s portfolios, rising equity valuations mean bonds have become a smaller portion of their total portfolio than ever before. There is also a substantial amount of excess cash in money market funds. Even with inflation remaining sticky, today’s real yields on Treasurys and high-grade bonds are higher than they’ve been for much of the last 20 years. Derisking equity allocations and/or rebalancing capital currently in money markets more broadly along the yield curve is certainly worth considering in the current environment.

We would also note that municipal bonds continue to offer compelling after-tax returns, and the fundamental outlook is stable. For higher earners with taxable investment accounts, tax-equivalent yields from municipal bonds can help further diversify portfolios with fair compensation across the yield curve.

The Relative Value of Municipal Bonds’ Tax-Equivalent Yield Is Near Post-GFC Highs

Back to the Basics: Where Will Fixed Income Returns Come From?

The challenge for attractive through-cycle returns is ensuring that even when the market is “risk-on” and nominal yields feel high, capital should still be lent only where the rewards and liquidity appropriately outweigh the risks. There are four key risks to consider in relation to a bond’s return profile:

1. Inflation: Are “risk-free” yields (in particular) attractively covering inflation’s expected impact on the principal that will be repaid at maturity?
2. Credit Risk: Are corporate and securitized spreads high enough above equivalent maturity risk-free yields (the “credit spread”) to allow through-cycle returns (after defaults, etc) to be sufficiently in excess of what’s available from Treasurys and other highly rated sovereign bonds?
3. Price Volatility: How will the bond’s price respond if macroeconomic or political conditions impact investor expectations after the time of purchase?
4. Duration: Partly embedded in the first three, and partly separate, is whether a bondholder is appropriately compensated for the length of time they’re exposed to these risks.

For 10+ years after the Global Financial Crisis (GFC), many central bank policies and certain fiscal policies kept a thumb on the scale for each of the components above.

• Zero/low interest rates and quantitative easing broke the traditional relationship between many developed countries’ government bond yields and inflation.
• Monetary and fiscal stimulus protected borrowers’ earnings, mitigating the normal credit risks for lenders.
• The largest central banks intervened with quantitative easing or by acting as bond buyers of last resort during volatility, which flattened the yield curve and encouraged the “buy any dip” psychology to become ingrained in many investors’ minds.

Central bank intervention has receded since 2022, and both real and nominal yields have risen. But as we’ll investigate below, in today’s market, the key component of most bonds’ return is simply the embedded risk-free rate rather than the issuer-specific risk considerations that were historically a primary driver of risk-based pricing. Below, and throughout these observations, we show the trends in Baa and B-rated bonds because they are indicative of the trends seen across all ratings categories for the investment grade and high yield spectrum.

Compensation for Inflation

Unfortunately, inflation remains out of its cage. The market is also grappling with uncertainty surrounding Kevin Warsh, including his policy leanings, whether ultimately hawkish or dovish, and his broader philosophy on how the Federal Reserve should operate and communicate with markets.

A combination of policy and cyclical dynamics have created a stickier inflation picture than many investors anticipated 6-12 months ago. It is also unclear how long the energy price shock will take to cycle through the various components of inflation. Consequently, the Fed’s messaging remains focused on avoiding the mistakes of the 1970s.

The Inflation Fight Is Still Not Over

In most years after the GFC and through COVID, real yields on risk free assets were barely positive and often even negative. Following 2022’s global central bank tightening cycle, real yields rose to levels not seen in nearly two decades.

Risk-Free Yields Are More Attractive Than at Most Points Since the GFC

In addition to positive real yields, the Treasury curve has a more attractive slope—relative to the broader environment—than we’ve seen in 15+ years. With low rates after the GFC, investors often used Treasurys only as a defensive tool. But today, extending duration offers a way to augment yield without dramatically increasing portfolio volatility or credit risk.

Treasurys Compensate for Duration, But Lower Grade Corporates Offer Limited Additional Yield

Beyond the slope of the curve or relative value to riskier assets, we note the change in opportunity over the last several years. Since 2023, corporate yields have compressed much more than we’ve seen for Treasurys. This is particularly true for the more speculative corporate categories. Consequently, the relative value of Treasury and high grade duration has increased compared to seeking yield through credit risk.

Change in Yields: July 31, 2026 vs…

In summary, the relative value of U.S. risk-free assets is currently providing a solid building block for portfolios given the protection against an uncertain inflation backdrop and the increased compensation for duration risk.

Compensation for Credit Risk

Risk premia have been incorporated into lending decisions for centuries. Across cultures, regions and economic eras, lenders have learned the hard way that regardless of how things look in the present, there are always bumps in the road over time.

As noted earlier, although nominal yields are higher today than for much of the last 20 years, this is largely because of inflation and higher real risk-free rates, rather than because risk premia (credit spreads) are actually more attractive. For investors taking corporate risk, the underlying Treasury yields are doing most of the heavy lifting to generate the carry. When nominal yields were higher in 2023, or at decade highs in 2018:

• A-rated and Baa-rated spreads were almost twice the current level (40-80bps higher)
• Ba-rated and B-rated spreads were 40-60% higher than the current level (100-160bps higher)

Nominal Yields Are High, But Embed Limited Risk-Based Pricing

We see in the following charts that defaults are a fact of life and that the magnitude of default rates can increase quickly. Since 1994:

• Investment grade Baa-rated bonds have experienced defaults in more than 40% of the years.
• Speculative B-rated bonds have seen defaults in every single one of the last 31 years.
• It’s also been a fairly frequent occurrence that defaults don’t just rise a bit year-over-year, but that defaults can quickly rise dramatically—doubling (or more) year over year.

Frequency of Elevated Default Rates (1994-2025, dollar-weighted)

Over the long term, it has also been common that bonds performing particularly well in the early years still experience “the normal” level of defaults in later years. The following illustrates the cumulative performance for Baa and B-rated bonds, been separating the cohorts with notably good performance in the first two years against all other years. Since 1994:

• There were eight issuance years where Baa bonds had zero defaults in the first two years.
• There were five issuance years where single-B bonds had less than a 2% default rate by the second year.
• Regardless of the first two years’ performance, the default experience from years 3-6 was similar.

Even After a “Strong Start,” Default Rates Migrate Higher in Later Years (1994-2025, issuer-weighted)

Most simply, history indicates that the longer things are better than average, the more important it becomes to be thoughtful about protecting a portfolio from risks ahead.

In risk-on markets, narratives often emerge to justify stretched pricing dynamics. A common refrain today is that “high yield spreads are tighter than in the past because the high yield index has a smaller share of the lowest quality credits compared to the past.” Yet a like-for-like review shows that historically low compensation for risk is not simply due to a “mix effect,” but is instead probably due to market exuberance.

The following charts show the recent evolution of credit spreads for the lowest end of investment grade (Baa) through the low end of high yield (Caa), plus Emerging Markets bonds. They also show the average spreads for the rating categories since 1994, but we are generous and “normalize” the averages by removing the highest 12 months in the GFC and the highest six months during COVID.

Yet even when giving the benefit of the doubt that the GFC and COVID were true one-off events, we see:

• Although Ba-rated bonds are considered speculative high yield and have historically defaulted over 3x more frequently than investment grade Baa-rated bonds, Ba-rated bonds are now trading at the long-term average spread level of the investment grade Baa category.
• Similarly, although B-rated bonds have historically defaulted over 4x more frequently than Ba-rated bonds, B-rated bonds are now trading at the long-term average spread level of the Ba category.
• In an otherwise risk-on market, Caa-rated bonds are flashing a warning signal, with spreads widening in recent months.
• The case for U.S. exceptionalism is also harder to make when emerging market bond spreads are trading at similarly tight levels.

Credit Spreads in All Categories Have Moved Far Below Their Long-term Average Levels

Is it truly possible that all types of borrowers, of all levels of credit quality, in all regions of the world, have really learned to avoid the business cycle? We are not so sure.

We know that even when astronauts are floating in outer space, gravity still exists. But such low compensation for credit risk leaves us wondering how many investors have forgotten the laws of physics (and the business cycle).

Rather than just comparing spread levels to their own history, it is essential to consider them against the pain of historical defaults. The risk is that because credit spreads are currently more like pennies and nickels, rather than quarters or silver dollars, the proverbial steamroller could be devastating when it appears.

The charts above show the absolute level of each rating category’s credit spread. The following chart subtracts the long-term average default rate (removing 2008 and 2020), so it is essentially an indication of the prospective one-year excess return from lower grade corporate bonds if defaults return to normal. It is unlikely anyone would deem the current net level to be attractive.

Option Adjusted Spread (OAS) – Long-term Average Default Rate (dollar-weighted)

Painful default waves are common enough that they should not be oversimplified as only a long-tail risk. We reviewed issuer-weighted and dollar value defaults since 1994 (the charts below show dollar-weighted outcomes). There have been multiple years when default rates exceeded current credit spreads, providing more substantiation of the reasons to always remain vigilant:

• In the left chart, we see frequency: in five of the last 32 years (16% of the time), Ba default rates were above current spreads. In the single B category, it’s happened 31% of the time.
• In the right chart, we see that in the worst years, default rates were multiple times higher than current spread levels.
• And even a return to the average default experience would erase the compensation for buying single B-rated bonds today. At the bottom of the high yield category, Caa bonds (at a high level) have offered very little gain relative to the frequency of pain.

Our takeaway? No matter how brightly the sun is shining today, the laws of physics (and business) mean that bond investors still need to carry an umbrella. Unfortunately, we cannot predict when it will rain next, but we are confident that not every day ahead will be sunny.

Price Volatility

The default risk above relates to why investors need to be compensated for the risk of permanently impairing capital. But there is also the risk that even without a default, price volatility can create unrealized losses, which might, for unrelated time horizon needs, become realized losses if one needs to sell.

The most commonly discussed driver of price volatility is interest rate sensitivity to changes in risk-free yields, but the widening or tightening of credit spreads is also meaningful. In 2022, the pain in bond markets was caused by the sensitivity to rising risk-free rates. Since then, compressing credit spreads have offset the additional increase in Treasury yields. But if Treasurys remain roughly stable while spreads widen back to normal levels, the bond market could find itself just as challenged as it was only a few years ago.

The following table illustrates the generic “bond math” for the price movement that bonds in different ratings categories would have experienced over the last several years. It assumes the generic bonds were issued in June 2023, June 2024, and June 2025, and shows how the price would have changed by June 2026, given the moves in underlying risk-free rates and credit spreads.

Going forward the key risk for bond prices (separate from risk free rates rising further or a default wave), would simply be if credit spreads widen for any one of many reasons—from macro or political fears to a change in liquidity conditions, to fear-led selling due to the apparent early stages of a default wave.

The following shows how widening credit spreads could erase much of the carry investors currently expect to earn over the course of a year. Just as it’s possible for a rise in defaults to erase returns for bond investors, a jump in credit spreads could also eliminate much or all of an investor’s expected return for a year.

Potential Impact to Bond Prices vs. Expected Carry

As investors search for yield, they should not forget that risks come not only from an issuer’s fundamental health and near-term default risk, but from the prospective price volatility related to movements in credit spreads. A consistent relative value framework helps balance fundamental risks and also factors in mitigating price volatility over the cycle.

Final Thought

While it makes sense to approach this market environment cautiously, none of this is a call to sit in cash or abandon credit altogether. It is a call to be paid appropriately for the risk one takes, rather than accepting whatever the index happens to offer. Right now, the index isn’t offering much.

The good news is that discipline doesn’t require heroics. Real yields on risk-free assets are doing more of the work than they have in over a decade, so investors don’t need to reach into the lowest-quality credits just to generate carry. And investors focused on bottom-up security analysis can still find pockets of opportunity—from structured product, to corners of corporate credit and municipal bonds—where the market hasn’t yet priced away the reward for showing up and doing the work.

We don’t know what the next catalyst for wider spreads looks like, but every cycle we’ve studied in modern history says the market eventually asks credit investors to answer for the risks they took during the good times. Boldness has recently experienced a short-term benefit from spread compression that has never before proven durable.

Fortune, in the long run, tends to favor discipline.