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Thought of the day

On Monday, US investment grade (IG) corporate bond spreads tightened to their narrowest levels in 25 years. ICE BofA data shows the gap between IG borrowing costs and US Treasuries is now just 0.75 percentage points. The most recent part of the rally reflects strong demand from investors who are rushing to lock in still-elevated yields ahead of anticipated Federa Reserve easing.

Although spreads are tight, we continue to see value in high-quality fixed income, as we expect yields to decline with upcoming Fed rate cuts, with carry boosting returns. Fed fund futures now indicate an 83% probability of easing at the September meeting.

High yields are the main driver of returns. While the compression in spreads means investors are being compensated with less risk premium, the more than 5% absolute yield level means carry will likely be the dominant driver of returns, especially as we expect policy rates to decline. Additionally, capital markets remain open, deals are oversubscribed, and financial conditions are loose, underscoring persistent demand from foreign and domestic investors alike. We believe this dynamic will keep IG attractive despite tight valuations.

Risks remain, but the macro backdrop supports further easing. Markets are pricing in roughly 125 basis points of Fed cuts through 2026, but expectations have moderated slightly after stronger producer price index (PPI) and retail sales data released last week. The main risk is a bear steepener, where easier Fed policy coincides with stronger growth, driving long yields higher and reigniting inflation concerns. But, while July inflation data showed an uptick in inflation, and early estimates of the Atlanta Fed’s GDPNow is tracking 2.5% growth for the third quarter, we expect shelter and services prices to slow, which should help bring down inflation. Moreover, while the resilience in spending is encouraging, headwinds still persist from tariff-related price increases and a softening labor market. Thus, we expect GDP growth to slow to around 1.5% this year and anticipate four quarter-point rate cuts by the Fed through January 2026.

Quality fixed income offers attractive risk-reward and diversification benefits. Lower policy rates are likely to push Treasury yields down, in our view. Accordingly, we expect government and investment grade bonds to deliver mid-single-digit returns over the next 12 months. Quality bonds also look appealing if US economic growth disappoints and data weaken more than expected, as yields would fall quickly, delivering significant capital gains. With current yields still attractive, investors should consider putting additional liquidity to work, as cash has historically underperformed on a longer-term basis. We prefer medium-duration quality bonds and see select credit opportunities across Asia and Europe.

So, with interest rates and bond yields set to fall, putting excess cash to work and seeking durable income should remain a strategic priority for investors. We favor medium-duration (five to seven years) high grade and investment grade bonds, as we remain alert to higher volatility at the long end of the curve. Watch our latest video on fixed income here.