Investment grade credit | Insight Investment

Market environment

US corporate spreads were 18bp tighter in May at a +88bp option adjusted spread (OAS), producing total returns of -0.01% and excess returns of 1.27%. May was the largest spread tightening month since November 2023. Investment-grade corporate spreads are just 14bp wide of the November 2024 low when the index was at +74bp. The strongest performance was from the energy, communications and basic industry sectors. The worst performing sectors were banking, insurance and consumer non-cyclical. ‘A’ rated corporate bonds were 15bp tighter and ‘BBBs’ were 22bp tighter on the month. Credit curves slightly steepened with intermediate spreads 18bp tighter and longer-dated spreads 17bp tighter.

European corporate spreads were 12bp tighter on the month at +100bp OAS producing total returns of 0.54% and excess returns of 0.60%. The best performing sectors were life insurance, automotive and banking, while the weakest sectors were chemicals, transportation and natural gas.

High yield spreads were 69bp tighter at +315 OAS, producing total returns of 1.68% and excess returns of 2.14%. May was largest monthly tightening since October 2022. Lower quality outperformed with ‘CCC’ rated debt returning 2.43%. The yield on the High Yield index decreased by 34bp during the month to 7.46%. There were $2.9bln in fallen angels, $14.8bn in rising stars and $500m defaults during the month.

US economic data reports provided few major surprises in May, as markets were focused more on political events and the backdrop of shifting trade tariffs. However, bond markets reacted when Moody’s credit rating agency downgraded the rating of US debt by one notch from Aaa to Aa1, while moving to a stable from a negative outlook. The move meant that all three major credit rating agencies have now stripped the US of the highest rating level. The labor market remained relatively robust as another 177,000 jobs were added in April, although the March data was revised down by more than 40,000. Average hourly earnings growth was unchanged at 3.8% year-on-year. Inflation edged slightly lower, reaching 2.3% at the headline level, with the core rate remaining unchanged at 2.8%. When considering sentiment indicators, many perspectives appeared to be modestly softer. The Institute of Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) declined once more as it reached 48.7, even though the market had anticipated a modest improvement, but the setback was much less than had occurred the previous month. The Michigan Consumer Sentiment Index initially fell further but was revised upwards later in the month to match the 52.2 level from the previous month. At its May policy-setting meeting, the Federal Reserve (Fed) left interest rates unchanged, as the market had widely anticipated.

Outlook

As the extended roll-out of trade tariffs and the ongoing volatility surrounding the timing and scale of them continues, how they eventually affect activity and inflation data adds greater uncertainty in our outlook and forecasts. The economy appeared to be entering 2025 with solid momentum but we believe it is increasingly vulnerable. The potential for a recession has increased but is not our central case. At present, we expect GDP growth to fall below the consensus forecasts and slow to 1.4% for 2025, and then degrade further to about 1.2% in 2026. Inflation is likely to remain above target at around 2.9% this year, before easing slightly to 2.7% in 2026. However, any rapidly escalating trade tensions could derail the current disinflation momentum and cause inflation to reaccelerate. Eyes will turn to the ‘One Big Beautiful Bill Act’ recently passed by the House of Representatives and its passage through the Senate. Many commentators suggest that its effects could substantially add to the US fiscal deficit and debt, potentially driving Treasury yields higher. For now, we expect the Fed to remain cautious, with only quarterly interest rate cuts likely for some time, with a terminal rate around 3% to 3.25%. Yields are likely to remain volatile but to trend gradually lower, with a 12-month forecast for 10-year yields of around 3.9%.

Technicals

Investment grade corporate issuance was $131bn in May, which was above initial expectations as more issuers returned to the market as spreads moved tighter throughout the month. Average maturity for investment-grade new issues was 8.7 years, which decreased from 10.2 years in May 2024 as more issuers opted for shorter maturities, as the Treasury curve remains steep. Flows into investment-grade credit funds in May were positive as risk sentiment improved and yields remained high. Yields have remained above 5% so we expect flows to remain neutral to positive in the near term. In May, Treasury yields increased with the 5-year Treasury yield increasing by 23bps to 3.96%, 10-year was 24bp higher to 4.40%, and 30yr was 25bps higher to 4.93%.

Fundamentals

Earnings for S&P 500 companies have remained strong, increasing 13.5% year over year, with 77.6% beating analyst forecasts. There has been an uptick in companies withdrawing or lowering guidance because of the increased uncertainty related to tariffs, but so far, the negative impact has not shown up in earnings. Liquidity profiles remain very strong as companies have still been able to issue new debt despite the spike in volatility in April.

Valuations

Investment grade spreads widened in April following the tariff announcements, reaching a new year-to-date high on April 8 at +119, but are now only 8bp wider year to date. Spreads in credit remain historically tight, however yields in credit are attractive over 5%. Our expectations for stable fundamentals and strong demand from yield buyers should keep spreads trading in their current range in the near term, although longer-term risks have increased with the new tariff announcements.

Risks

• Geopolitical risks
• Negative impacts from announced tariffs on growth and inflation
• Increase in debt-funded M&A and shareholder returns