What’s driving investment grade and where might it be headed?

Investment grade bonds are up 2.34% this year, with much of its solid performance driven by a rally in intermediate yields.¹ There has been a lot going on under the hood. Here’s our insights about the various market drivers year-to-date, and where we think investment grade is headed in the coming months.

Craig: Let’s start with rates since they have been the biggest driver of returns this year. They moved late last year, reflecting uncertainty over what the new Trump administration’s policies could mean for inflation. What’s your view on rates in the coming months?

Matt: The market started the year concerned about inflation driven by animal spirits (emotions) as the Trump administration was sworn in. We had a hot Consumer Price Index (CPI) print in January, but inflation has slowed and the focus has shifted toward future growth. Markets are concerned about tariffs and their potential negative impact on the economy. There’s also concern around immigration policy, which could be growth-negative. Whether tariffs are inflationary, or just one-time price resets, is debatable, but the Federal Reserve (Fed) will likely need to navigate the price impacts of tariffs at the same time that the US economy may be slowing. Given a slower growth outlook, we’d expect the Fed to look through the inflationary impact of tariffs, allowing rates to go lower.

Craig: How have earnings been for industrials? Is credit expansion continuing to drive growth?

Matt: We've seen strong earnings from industrials this year. Utilities have had a somewhat more mixed performance. But if you look at traditional US industrials, they’ve done well.² The outlook going forward may be more negative or mixed, however. As earnings reports have come out, a lot of companies have beat expectations, but guided forward expectations were down, particularly for consumer-related companies.

Corporate balance sheets are still in good shape overall. There has been a fair amount of issuance in the investment grade market and some in high yield, but it's been well received. Some companies are taking on debt to pay down debt coming due from previous years, but they appear to be aimed at not levering up.

Craig: Bonds have been negatively correlated to stocks in recent selloffs, such as January’s DeepSeek-related one. What did bonds do during the March stock correction?

Todd: Bonds performed as expected — they were inversely correlated to stocks in these risk-off events. Whenever we’ve had a selloff this year, interest rates have fallen and bonds have rallied. That’s exactly why they may be beneficial in a mix of assets, in our view, for that inverse correlation. With so much uncertainty, especially around growth, we think this negative correlation will continue throughout the rest of the year. Also, many investors have been yield buyers. Upward corrections in yields have the potential to draw buyers back into the market, so bonds could perform well in different situations.

Craig: Investment grade rating upgrades have outstripped downgrades, but Celanase and Nissan were downgraded to high yield. Do you think it’s symptomatic of broader trends or are they idiosyncratic? Also, are there any changes to your bull and bear cases for credit spreads this year?

Todd: The ratio of investment grade credit upgrades to downgrades has risen sharply since the 2020 COVID-19 crisis, to a record 4.7 in 2024.³ Celanese, a global chemical company, and the carmaker Nissan are two one-off situations, in our view, because the companies were poorly run and the downgrades weren’t related to broader fundamental concerns, such as tariffs.

At the end of the day, we still expect more upgrades than downgrades going forward. Of course, if tariffs cause economic activity to slow sharply in the second half of the year, fundamentals could be more challenged, but that isn’t our base case.

For spread expectations, our bull case (15%-20% probability) was for a 55 basis point spread on the investment grade index. That was predicated on a high all-in yield of 4.5% or more on the 10-year Treasury, but not exceeding 5%. In other words, our bull case was dependent on being in the sweet spot of the high 4% level in rates, but without the fear of blowing through the high end of the recent trading range, which might cause panic.

We believed that the high end of the range would likely attract yield-based buyers, such as insurance companies, annuities, and pension plans. Now that we’re trading in the low 4% range on the 10-year Treasury, we’re less optimistic about how much tighter spreads can go.

Our bear case was a widening to around a 120 basis points spread on the index, which has a very small probability, in our view. A key tail risk would be a serious policy misstep, for example. But though there is much volatility and noise around policy, we don't believe economic outcomes will be drastically negative.

Craig: We’ve had spirited debates about the consumer lately. It seems like there’s some softness at the lower end of the consumer spectrum, which has yet to show up in the macro numbers. Have you made any portfolio positioning shifts, or are you thinking about any new risks based on divergent consumer strength and behavior?

Matt: We recently did a deep dive on the consumer. The general conclusion was that there are consumer market segments that are getting squeezed, especially on the lower income end. Is the squeeze big enough to have an impact on the trajectory of the economy and potentially widen credit spreads? We don't think so. We expect some economic slowing this year, so we want to be cautious on certain areas of the economy that could be impacted, like subprime auto and credit card loans. The auto companies could also be susceptible, including foreign ones that could be hit by tariffs. So, we’ve been cautious on areas that could be impacted by a pullback from lower-end consumers. But we don't expect the current consumer dynamics to change the direction of gross domestic product (GDP) or the overall economy at this juncture.