Mid-Year Fixed Income Outlook: Uncertainty Yields Tight Credit Spreads

As we look to the second half of the year and beyond, these themes are still relevant. We continue to maintain a comprehensive market mosaic within the foundation of an active global investing perspective.

April Volatility

Fixed income markets dislocated in April, but primarily due to capital flows rather than a credit event. This was nothing like Silicon Valley Bank’s insolvency, and high interest rates haven’t yet created any surprises in mortgages or corporate bonds. The MOVE Index measures U.S. bond market volatility, and when looking at its 90-day rolling average, we actually see that its volatility has been slowly trending down since it spiked with the Fed’s aggressive interest rate hikes in 2022.

U.S. Bond Market Volatility

Source: Bloomberg

Will Investors Talk About the Government’s Fiscal Deficits and Debt Outstanding?

While the developing AI story reflects a debate about corporate capital allocation, we also seem to be at the beginning of an actual debate about government capital allocation.
GDP = Consumption +/- Net Exports/Imports + Investment + Government Spending. It is essential to remember that although net exports increase GDP while net imports detract from GDP, the debt incurred for consumption or government spending is not incorporated into GDP calculations.
If nominal GDP grows faster than the fiscal deficit, a country’s debt/GDP ratio declines (because the denominator grows faster than the numerator). If a country has high economic growth, but an even larger fiscal deficit, its debt/GDP ratio increases. But the fact that borrowing was required to generate the GDP growth is not considered in the GDP calculation itself.
The U.S. has maintained notably strong growth since the financial crisis, and while emerging from COVID, particularly in comparison to other developed countries. Many countries have been more conservative than the U.S. over the last decade when it comes to deficit spending. Particularly in Europe and some emerging markets, this fiscal caution limited GDP growth because there was far less stimulus (lower taxes or higher spending) compared to the U.S.
Consider the following perspective on why the U.S. had exceptionally strong GDP growth compared to other parts of the world, before considering differences in consumer borrowing trends. The U.S. government borrowed 1-3% more of GDP than other countries, which allowed its economy to grow several points faster.

Average Fiscal Deficit

Source: Bloomberg
For the past 25 years, regardless of who controlled Washington, DC, the U.S. government generally reduced federal revenue (taxes) while still increasing spending. The just-passed “One Big Beautiful Bill Act” (OBBBA) also reduces taxes, but reduces spending as well. Supporters believe the tax reductions (and other regulatory changes) will enhance growth, while detractors argue the economic benefits do not outweigh the fiscal costs.
The U.S. has been unable to grow its way out of fiscal challenges for the last 15-plus years, but it will take a year or more to begin to see the fiscal and economic impact of the OBBBA, and even longer to have enough information to pass final judgment. For example, we know that deficits widened during the first Trump administration, but the COVID pandemic complicated a full assessment of its benefits and costs. Unfortunately, no single policy is a panacea, and it is highly unlikely that there will be a bill that solves it all.

Cause and Effect: The US Fiscal Deficit and Debt

Source: Bloomberg
However, it’s a positive development that deficit complexities are no longer hiding in the shadows and that people will continue talking openly about the unsustainability of the current U.S. fiscal situation. Essentially, the U.S. has two main levers to improve the situation: reduce federal spending or raise taxes. Tax increases are now off the table, but for the first time in many years, federal spending could be restrictive for years to come.
Restrictive U.S. policies contrast with the transition taking place in other major economies. Outside the U.S., countries with more fiscal dry powder (such as Germany at 63% debt/GDP, the overall Eurozone at 87% debt/GDP, or Canada and Mexico at about 100% and below 60%, respectively) are now incorporating more stimulative policies to accelerate the transformation of their economies in relation to the realignment in global trade, defense, energy security, and modernizing infrastructure.

A “Normalization” in the Global Cost of Capital

Because the U.S. has been a key reserve currency for almost 80 years, since the end of World War II, the dollar and interest rates have been allowed to defy the laws of economics. Other countries with “twin deficits” (fiscal deficits and trade deficits) have seen their currency fall and/or global investors demand higher interest rates (“bond vigilantes”). But U.S. consumers and corporates have benefited from what’s been termed the dollar’s exorbitant privilege.
Two trends are now reversing: First, the Federal Reserve has intervened in various ways since the financial crisis to suppress interest rates, but it now seems to have a lower willingness to do so. Second, as the U.S. seeks to realign trade relationships, other countries are rethinking their relationship with the dollar as a reserve currency. Without reasonably coordinated global central bank policies that protect the dollar and/or drive flows into US Treasuries, the U.S. government may be moving into an environment where it must also pay rates that reflect the actual risks of the U.S. fiscal situation.
A higher yield environment for US Treasuries, often termed the “risk-free” benchmark, makes it important for investors to consider relative value across global asset classes. Higher interest expense for corporates can reduce net profits or dividend payouts, or higher interest expense can strain corporates’ and consumers’ ability to repay what they borrow.
For nearly 40 years, the yield fell on US 10-year Treasuries. For borrowers looking to refinance, the risk-free benchmark was almost always lower than it was when they’d issued the original debt. For this period, refinancing could be counted on to free up cash flow. But now, it appears we’re in a world where borrowers will consistently be borrowing new money with a higher underlying risk-free rate than their prior debt, reducing the cash flow available after paying the interest.
The following chart illustrates the change in this long-term trend. The orange line is the US 10-Year Treasury Yield since 1975, which has fallen from 8% in 1975 to the mid-4% range today. Looking forward, we make a ballpark assumption (dotted line) that inflation will remain at a comfortable level for the Federal Reserve, leading to rate cuts which allow the 10-Year Yield to fall to 3% by late 2026. The green line shows the rolling change in yield over 10-year periods, and for decades, the green line was in negative territory (falling rates compared to the prior decade). But now, the dotted green line reflects that, even if the 10-Year Treasury Yield falls to 3% in future years, borrowers will still be paying higher rates than they were 10 years earlier.

Indicative Refinancing Impact from Changing “Risk Free” Rates

Source: Bloomberg

Tracking Credit Spreads

Beyond rising sovereign yields, we’ll need to wait to see if credit spreads remain tight relative to history or widen to reflect a less predictable environment. After briefly widening in April, both investment grade and high yield spreads have come back in and are near “all-time tight” levels.

US Corporate Option-Adjusted Credit Spreads

Source: Bloomberg
Risk premia may indicate investor complacency with corporate risks, or perhaps there is an undercurrent of debate about whether governments or corporates are safer credits.

Consensus Estimates for Total Return

Source: Bloomberg
There is a complicated balance for identifying where value lays, and where investment opportunities offer asymmetric return potential. Among considerations for earning an appropriate real return:

• US Treasuries: Evidence of fiscal discipline would do much to bolster support and sentiment for Treasuries. Inflation remains higher than desirable, but it’s also true that real yields are more attractive than they have been since the mid-2000s. It remains important to track the inflationary impact from tariffs, a weakening dollar, and immigration’s impact on labor supply and wages.
• US Corporate Bonds: Credit spreads are notably tighter than average. Many highlight that “all-in yields” are attractive (since Treasuries’ real yields have improved), but it remains to be seen how spreads might react to lower “risk-free” rates or renewed macro volatility.
• US Municipal Bonds: Heavy issuance and seasonality have created opportunities in the tax-exempt space, particularly for those in higher tax brackets. While the OBBBA provides near-term visibility into tax rates, we suspect that over time, individual tax rates are more likely to increase than decrease, given the fiscal picture. Occasional uncertainty about a reversal in the bonds’ tax-exempt status could also create buying opportunities.

Final Thoughts

For fixed income investors, the compensation for leaning into risk is not clear, particularly with the variety of uncertain outcomes ahead. Conservative positioning, given the best real yields in two decades, is a reasonable way to maintain dry powder should we see another dislocation like April.