Corporate Bonds: Mid-Year 2025 Outlook

Looking ahead to the second half, we believe that excess returns—returns above the returns of comparable U.S. Treasury securities—could be limited given tight valuations. The extra yield that lower-rated investments currently offer over investments with higher credit quality is very low, setting a very high bar for outperformance.

We continue to favor highly rated investment-grade bonds, and to suggest that investors willing to take a little extra risk to potentially earn higher yields do so in moderation.

Coming into the year, we believed U.S. corporations were generally on solid footing. While there were pockets of weakness, specifically with lower-rated, highly leveraged companies, the fundamentals in aggregate were strong. That trend appears to be shifting.

Corporate profits declined in the first quarter of 2025. The 2.9% drop in the first quarter was the largest decline since the fourth quarter of 2020, and the second decline over the past three quarters. The level is still relatively high, however—according to the Bureau of Economic Analysis, U.S. corporate profits (before tax) were $3.9 trillion in the first quarter, compared to just $2.9 trillion in 4Q 2019.

Corporate balance sheets also have weakened recently and are coming down from levels that are weaker than initially reported. The Federal Reserve reports aggregate corporate balance sheet data in its quarterly "Financial Accounts of the United States" report, also known as the Z1 report. The report includes the ratio of liquid assets relative to short-term liabilities for nonfinancial corporate businesses. The decline to 90% in the first quarter of this year from 95% at the end of 2024 was noteworthy, but revisions were even more noteworthy. The 4Q 2024 ratio of liquid assets to short-term liabilities was initially reported at 104%, only to be revised down to 95% with the 1Q 2025 release.

We continue to find investment-grade corporate bonds attractive given their currently high absolute yields. Although corporate fundamentals appear to be weakening, investment-grade corporations have their investment-grade ratings for a reason. They tend to have more diversified business models, stable cash flows, and low debt levels relative to their earnings.

Although yields are high, spreads—the extra compensation that corporates offer above comparable Treasuries—are low. That doesn't worry us too much, because we believe investment-grade corporations would be able to weather slower economic growth should that occur.

The chart below breaks down the average yield-to-worst of the Bloomberg US Corporate Bond Index, as represented by the dashed line at the top, and then broken down by the spread component and the Treasury yield component.

Average yields are still near the high end of their 15-year range. The average yield-to-worst of the Bloomberg US Corporate Bond Index has hovered between 4.75% and 6.5% since late 2022; in the years following the global financial crisis of 2008/2009, the average yield of the index rarely got above 4%.

The average option-adjusted spread of the index is low, with the average option-adjusted spread of the index at just 85 basis points (or 0.85%) as of June 20, 2025. Of the roughly 5.2% yield that the index currently offers, roughly 4.35% of that is coming from the level of Treasury yields, and just 0.85% is risk compensation.

Investment-grade floaters may make sense, as well. Investment-grade floating-rate notes, or "floaters," are a type of corporate bond whose coupon rate is composed of a short-term reference rate plus a spread. The reference rate can vary, but it's usually the Secured Overnight Financing Rate (SOFR)—a daily rate based on transactions in the Treasury repurchase market—which is highly correlated to the Federal Reserve's benchmark federal funds rate.

Expectations for the timing, pace, and magnitude of potential central bank interest rate cuts by the end of this year and beyond are fluid, but the number of cuts has been dialed back lately. Additional Federal Reserve rate cuts would pull coupon rates lower, but that shift in expectations for the number of rate cuts means that coupon rates might not fall much further.

Historically, fixed-rate corporate bonds have offered higher yields than floaters, but that shifted recently given the inverted yield curve. Now the average yields-to-worst of the Bloomberg US Floating Rate Notes Index and the Bloomberg US Corporate Intermediate-term Bond Index are very similar, with floaters currently offering a slight advantage.

Floater prices are generally much more stable than fixed-rate corporate bonds. They can still fluctuate in the secondary market, and can decline if the economic outlook deteriorates, but their prices are much more sensitive to credit risk than to interest rate risk. Since the Fed began cutting rates in September 2024, floaters have actually outperformed fixed-rate, intermediate-term investment-grade corporate bonds, and with much less volatility. The outperformance might be difficult to replicate if the Federal Reserve does cut rates, but the low volatility should remain.

U.S. high-yield corporate bond spreads are low again. They rose sharply in early April as the initial tariff announcement spooked the markets, but just like the equity market rebound, spreads fell (and high-yield bond prices rose) as the tariffs were pared back.

The average option-adjusted spread of the Bloomberg US Corporate High-Yield Bond Index closed at just 2.99% on June 20th. That’s an historically low spread—over the last 15 years, the average spread has only been lower 10% of the time. Put differently, 90% of the time over the last 15 years, investors earned higher yields relative to Treasuries than they do today.

We think high-yield bonds make the most sense when investors are compensated well for their risks, but that's not really the case today. Low spreads also mean that there's less cushion in case the economic outlook deteriorates and high-yield bond prices fall.

When spreads rise, the prices of high-yield corporate bonds fall relative to Treasuries. With spreads near 3% or lower, there just isn't much room to fall even if the economic outlook were to improve, yet there's plenty of room for them to rise. Historically, when spreads are 3% or less, high-yield bonds tend to underperform Treasuries more than twice as often as they outperform Treasuries.

The chart below highlights how often the Bloomberg US Corporate High-Yield Bond Index outperforms (or has "excess returns") relative to US Treasuries over 12-month periods, depending on where the starting spread was. When the average spread was 3% or less (the red shaded area below), high-yield bonds only outperformed Treasuries 30% of the time. When spreads were 5% or more (the green shaded area below), high-yield bonds outperformed Treasuries 93% of the time.

Although high-yield bonds have performed well in 2025, there are cracks under the surface. The number of high-yield corporate defaults remains elevated, with high borrowing costs and an uncertain economic outlook weighing on corporate profitability. According to Standard and Poor's (S&P), the trailing 12-month sub-investment-grade¹ default rate has held above 4% for the 20 months ending May 2025, in-line with the 20-year average near 4.5%. S&P expects the default to decline from May's 4.3% rate to 4.0% by next March—while the decline would be welcomed, the rate itself is still somewhat high.

The combination of elevated risks but low spreads are what drive our "neutral with a dash of caution" outlook. Despite the low spreads, average yields for high-yield bonds remain above 7%, so they can still make sense in moderation for investors looking for high income and who have the ability to ride out potential ups and downs. From a tactical standpoint, we'd find high-yield bonds more attractive if their spreads got to the 4.5% to 5% range, as those levels have historically resulted in a higher likelihood of outperformance relative to Treasuries.

Preferred securities have rebounded from their April 2025 lows. Preferred securities have characteristics of both stock and bonds, and they are sensitive to movements in both the stock and the bond markets. After the initial tariff announcement, preferreds acted a lot more like stocks than bonds as their prices fell sharply. Prices have since rebounded a bit, but yields remain elevated.

In late 2024 and earlier this year, the average yields on preferred securities were pretty similar to the average yields on corporate bonds with average credit ratings of BBB/Baa. Because preferred securities tend to have average credit ratings near BBB/Baa, that provides a more apples-to-apples comparison than the broad investment-grade corporate bond market, which includes a lot of "A" rated bonds, with some AAA and AA rated bonds as well. Preferrreds now offer slightly higher yields than like-rated corporates, bringing the risk/reward more into balance. As preferred securities rank lower than traditional bonds, they should offer higher yields.

Preferred securities can also offer tax advantages and can 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.

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 fixed income market in moderation.

For now, we prefer high-quality investment-grade corporate bonds given their balance of low-to-modest credit risk. Even if corporate fundamentals have weakened in aggregate, investment-grade issuers should be able to weather a potential economic slowdown better than issuers with lower ratings. Bond investors willing to take a little more risk can consider preferred securities, as they offer a modest yield advantage over similarly rated corporate bonds. Their potential tax benefits make them even more attractive for investors in higher tax brackets who are holding them in taxable accounts.

High-yield bond spreads are low and 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 in the 4.5% to 5% area or higher before we'd suggest investors tactically add them to portfolios.