The corporate bond markets were rattled by the early April tariff announcements. High-yield bonds and preferred securities generally suffered larger price declines than investment-grade corporates as increased uncertainty and economic growth concerns weighed on the riskier parts of the bond market.
The markets have calmed down a bit as some of the tariffs were rolled back, but the outlook remains cloudy. We maintain our "up in quality" guidance, favoring highly rated bond investments for now, but if relative yields were to rise more—sending prices lower—our outlook on riskier bond investments would likely turn more positive, potentially presenting investors an opportunity to tactically add some lower-rated investments to their bond portfolio.
We have three key takeaways for investors:
- High-yield bond spreads are up recently but aren't yet high from a historical standpoint. Investors can consider high-yield bonds in moderation, but we wouldn't be overweight or adding to positions just yet.
- Investment-grade corporate bonds remain attractive given strong fundamentals and a positively sloped yield curve.
- Preferred securities have become more attractive since their prices have fallen, but volatility should remain elevated. Investors willing to take more risk should favor preferred securities over high-yield bonds today.
High-yield bond spreads are up but are not yet "high"
High-yield credit spreads rose sharply following the initial White House tariff announcement on April 2nd. A credit spread is the extra yield that a non-Treasury security offers above a Treasury with a comparable maturity, and they are an indication of risk. When perceived risks are low, investors accept low spreads (less yield compensation over comparable Treasuries) because the risk of a failed repayment is generally low. But when the economic outlook deteriorates, investors tend to demand higher spreads as the risk of default rises.
Spreads had already begun to rise from their February lows on economic growth concerns from declining consumer confidence surveys. The average spread of the Bloomberg US Corporate High-Yield Bond Index dropped below 2.6% in the middle of February, began to gradually increase, but then surged as high as 4.5% after the tariff announcements. The spread rose by 53 basis points (or 0.53%) on Thursday April 3rd, the largest one-day increase since March 2020. From the mid-February trough to the April 8th peak of 4.53%, spreads rose by 197 basis points in just seven weeks.
High-yield credit spreads have risen
The jump in spreads shown above looks large when viewed from a short-term lens, but the level is still well below previous peaks during recessions or other "risk off" environments. The chart below offers a more long-term look at high-yield spreads. As you can see, at 4.1% the average spread of the high-yield index is still below its 20-year average of 4.8%.
High-yield credit spreads are well below previous peaks
High yield bonds generally look more attractive when spreads rise since it means higher yields compared to Treasuries. High-yield spreads are still up by more than one percentage point since mid-February, but risks still appear elevated. If tariffs remain in place, corporations may see less demand for their goods because higher prices, should they get passed along to consumers, mean less money for people to spend elsewhere. Corporations may also choose to absorb some of the tariff themselves, eating into their corporate profit margins. Given those risks today, we'd prefer to see spreads at least at their long-term averages, so if spreads got closer to 5%, we'll likely begin to turn more positive.
For now, we maintain our cautious stance not just because we prefer that investors earn higher relative yields if they are considering high-yield bonds today, but because spread increases generally result in price declines. The chart below compares the average price of the Bloomberg US Treasury Intermediate Index and the Bloomberg US Corporate High-Yield Index. Treasury prices dipped a bit after initially rising in early April, but the average price of the high-yield index is down roughly $3 since the tariffs were announced. If spreads continue to rise, high-yield bond prices likely would continue to fall relative to Treasuries.
The price spread between high-yield bonds and Treasuries has widened
Investors can still consider high-yield bonds in moderation given their high overall yields. While spreads are below average, the average yield-to-worst (the lowest yield that can be received on a bond with a call option) of the Bloomberg US Corporate High-Yield Bond Index is above the 15-year median. The level of Treasury yields is a key driver of today's high yields—the Federal Reserve held its benchmark interest rate near zero from late 2008 through late 2015, compared to the current federal funds rate in the 4.25%-to-4.5% range.
Over time, there is usually some degree of "credit loss" from high-yield bonds because high-yield issuers can and do default, so the annualized return of the high-yield index is usually a bit less than that starting yield. Over the past 15 years, the average yield-to-worst of the Bloomberg US Corporate High-Yield Bond Index was 6.7%, compared to the average annualized total return of 6.2%, highlighting how defaults can pull down returns over time. Investors considering high-yield bond investments, like a mutual fund or ETF, that track an index like the Bloomberg US Corporate High-Yield Bond Index could look to the starting yield as a good starting point for what to expect for longer-term annualized returns, but understand that defaults over time usually result in an average annualized return lower than that starting yield.
The average yield of the Bloomberg US Corporate High-Yield Bond Index is over 8%, above the 15-year median
Investment-grade corporates still appear attractive
We prefer higher-quality investments, like investment-grade corporate bonds, for most investors today. Investment-grade corporate bond spreads have risen lately, as well, but the magnitude has been much less than the increase in high-yield bond spreads. While economic growth concerns can weigh on corporate profits, investment grade issuers generally have strong balance sheets to weather a potential downturn.
That doesn't mean spreads can't keep rising or prices can't decline, but they should perform better than high-yield bonds during "risk off" environments. Investors can still earn yields in the 5%-or-higher range with intermediate-term investment grade corporates.
The investment-grade yield curve is also more positively sloped than the Treasury curve. Treasury investors might not feel incentivized to consider intermediate-term maturities if they are only earning 0.4% or less in additional yield compared to Treasury bills. Meanwhile, investment-grade corporates with maturities in the 5- to 10-year area can offer yields around 5.5% or more.
Investment-grade corporates currently offer higher yields than comparable Treasuries
Preferred securities have become more attractive, but volatility should remain elevated
Preferred securities have been hit hard given the market volatility. Preferred securities have characteristics of both stock and bonds, and which asset class they tend to follow depends on the market and economic environment. After the initial tariff announcement, preferreds acted a lot more like stocks than bonds as their prices dropped.
Preferred securities prices dropped sharply after the tariff announcement
While preferred prices should remain volatile over the short run, the entry point for long-term investors is more attractive today. The average price of the ICE BofA Fixed Rate Preferred Securities Index is now at its lowest level in 18 months.
While we are generally comfortable with the credit quality of the highly rated preferred market—meaning those with investment-grade ratings or issues at the top rung of the high-yield rating spectrum—volatility should continue and there could be further price declines.
Preferred securities prices have dropped
Preferreds can also make sense for investors in high tax brackets who are considering them for taxable accounts. Many preferred stocks pay qualified dividends that are subject to lower tax rates than traditional interest income. Investors considering preferreds relative to other investments should always consider what type of account they'll be held in—taxable or tax-advantaged—and if held in taxable accounts, the after-tax yield. Not all preferred stocks or securities pay qualified dividends—some pay interest—so it's important to know what you own and what the tax consequences are. Qualified dividends are generally taxed at 0%, 15%, or 20% rates, depending on income limits.
Those lower rates can be an advantage for investors in high tax brackets because the income payments from most taxable bond investments are taxed at income tax rates. On an after-tax basis, preferreds that pay qualified dividends can offer higher yields than high-yield bonds, but generally with higher credit ratings.
What to consider now
We continue to suggest an "up in quality" fixed income bias for the short run, but investors can still consider some of the riskier parts of the market in moderation.
For now we prefer investment-grade corporate bonds given their balance of low-to-modest credit risk, as their strong fundamentals can help them weather a potential economic slowdown. Investors willing to take a little more risk can consider preferred securities, as their prices have fallen lately, but should consider them long-term investments and be prepared to ride out potential volatility.
High-yield bond spreads have risen, but we'd prefer to see them rise a bit more before we take a more positive view. They can be considered in moderation, but we'd rather see spreads near 5% or more before we'd suggest investors tactically add them to portfolios.
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