Investors have been preparing for potential rate cuts by the Federal Reserve and other major central banks by buying up investment grade (IG) and high-yield (HY) credit to lock in elevated yields. As a result, credit spreads have narrowed to near 10-year lows: The U.S. IG spread is currently +89 bp and U.S. HY spread is currently +308 bp.1 In terms of expensiveness over the past decade, this puts U.S. IG spreads in the 94th percentile, and HY spreads in the 92nd percentile.
The current situation presents an interesting dilemma: U.S. credit yields are at multi-decade highs, but credit spreads are at multi-decade lows. The market’s confidence in credit conditions seems to indicate that it expects a soft landing for the economy. Unfortunately, tight credit spreads also imply that the risk-reward for credit returns is not as favorable, and probably negatively skewed to the downside. Given that cash is yielding around 5.4% (slightly below US IG’s 5.7%), the credit rally may be running out of road.
Given the risk-reward setup, it still makes sense for investors to be overweight equities, as equities can benefit from both rising valuations and better-than-expected earnings growth. On the fixed income side, an overweight to short-term bonds seems logical as interest rates are increasingly forecast to remain higher for longer.
Maverick Lin contributed to this article.