Credit selection key while fiscal expansion pressures sovereign bonds

While credit spreads¹ at near‑record narrow levels received much of the attention in 2025, we think there will still be credit market opportunities in 2026. However, elevated valuations will make strong credit selection essential. Value will be harder to find in high‑quality government bonds, where waves of fiscal expansion are pushing supply and yields higher in a competition to attract buyers.

Yields to remain attractive versus long‑term equity returns

Despite the tight spreads, sub-investment-grade bonds and bank loans are on track to provide yields that remain attractive versus long‑term equity returns. Many credit buyers focus more on yield to maturity than spread because they tend to hold the bonds or loans to maturity.

From a credit quality perspective, we don’t see many particularly concerning trends in fundamentals—issuer balance sheets are still solid, capital markets access remains robust, and we anticipate that default rates will stay below long‑term averages. That being said, there have been some “later cycle” credit behaviors that heighten the value of credit selection.

U.S. fiscal stimulus is just beginning to spread through the economy, with the bulk of the impact likely to reach issuers in the first half of 2026. Merger and acquisition activity has also accelerated as the U.S. administration has eased regulatory scrutiny of deals, which is generally supportive of high yield bonds and loans.

Disciplined credit selection will be essential

Despite the supportive backdrop, disciplined credit selection will remain essential in 2026. We anticipate isolated defaults and distressed credit events like those experienced by First Brands, New Fortress Energy, and Saks Global in 2025.

Favor bank loans over high yield bonds for income

Within the broad non-investment-grade credit asset class, high yield bond and loan valuations are roughly equal. We marginally favor loans over sub-investment-grade bonds for their higher current income.

The risks to our constructive outlook for credit include spreads that could widen quickly in the unlikely event that the economy slips into recession. A steep decrease in short‑term rates would sharply lower the income from bank loans (loans have floating coupons that adjust based on short‑term market rates)—but this also seems unlikely.

Expansionary fiscal policy driving government bond yields higher  

Long‑maturity government bond yields are a different story. Expansionary fiscal policy in the U.S., the UK, and some eurozone countries—notably Germany and France—is forcing developed market governments to fund deficit spending by issuing new debt. This raises questions about the long‑run sustainability of their debt and forces governments to offer higher yields.

The Federal Reserve, the Bank of England, and the European Central Bank face structural changes in job markets stemming from AI, labor force aging, and falling immigration. These factors are decreasing employment, boosting the tension between easing monetary policy to help labor markets and holding rates steady (or raising them) to keep inflation under control. This dilemma is especially acute for the Fed, which is facing more political pressure than it has at any time since the early 1970s.

To maintain employment growth, central banks may ultimately lean toward running policy looser than they would otherwise. This contributes to inflation risk, reinforcing the outlook for higher longer‑maturity yields, particularly on U.S. Treasuries.

Opportunities in inflation protected bonds

So, where are we finding opportunities in rates markets? Inflation protected bonds in the U.S. as well as some European countries and Japan represent attractive value, with those markets underpricing our anticipated inflation. We’re seeing select opportunities in emerging market nominal² government bonds—the Czech Republic, Thailand, and Latin American nations like Brazil and Chile.

Key takeaway
We anticipate there will be selective opportunities in credit, but expansionary fiscal policy will drive longer‑maturity government bond yields higher.

 

 

Appendix

Financial Terms: Investors in the U.S. and Canada, for a glossary of financial terms, please go to troweprice.com/glossary.

Investment Risks:

Active investing may have higher costs than passive investing and may underperform the broad market or passive peers with similar objectives. Each person’s investing situation and circumstances differ. Investors should take all considerations into account before investing.

International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. The risks of international investing are heightened for investments in emerging market and frontier market countries. Emerging and frontier market countries tend to have economic structures that are less diverse and mature, and political systems that are less stable, than those of developed market countries.

Commodities are subject to increased risks such as higher price volatility, geopolitical and other risks. Commodity prices can be subject to extreme volatility and significant price swings.

Inflation-Linked Bonds (Treasury Inflation Protected Securities in the U.S.): In periods of no or low inflation, other types of bonds, such as US Treasury Bonds, may perform better than Treasury Inflation Protected Securities (TIPS).

Investing in technology stocks entails specific risks, including the potential for wide variations in performance and usually wide price swings, up and down. Technology companies can be affected by, among other things, intense competition, government regulation, earnings disappointments, dependency on patent protection and rapid obsolescence of products and services due to technological innovations or changing consumer preferences.

Because of the cyclical nature of natural resource companies, their stock prices and rates of earnings growth may follow an irregular path.

Financial services companies may be hurt when interest rates rise sharply and may be vulnerable to rapidly rising inflation. Health sciences firms are often dependent on government funding and regulation and are vulnerable to product liability lawsuits and competition from low-cost generic product.

The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. Growth stocks are subject to the volatility inherent in common stock investing, and their share price may fluctuate more than that of a income-oriented stocks.

Small‑cap stocks have generally been more volatile in price than the large‑cap stocks. Investing in private companies involves greater risk than investing in stocks of established publicly traded companies. Risks include potential loss of capital, illiquidity, less available information and difficulty in valuating private companies. They are not suitable, nor available, for all investors.

All investments involve risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market. Index performance is for illustrative purposes only and is not indicative of any specific investment. Investors cannot invest directly in an index.

Fixed‑income securities are subject to credit risk, liquidity risk, call risk, and interest‑rate risk. As interest rates rise, bond prices generally fall. Investments in high‑yield bonds involve greater risk of price volatility, illiquidity, and default than higher‑rated debt securities. Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Some or all alternative investments such as private credit, may not be suitable for certain investors. Alternative investments are typically speculative and involve a substantial degree of risk. In addition, the fees and expenses charged may be higher than the fees and expenses of other investment alternatives, which will reduce profits. As interest rates rise, bond prices generally fall. Investments in high yield bonds involve greater risk of price volatility, illiquidity, and default than higher rated debt securities.

T. Rowe Price cautions that economic estimates and forward‑looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual outcomes could differ materially from those anticipated in estimates and forward‑looking statements, and future results could differ materially from any historical performance. The information presented herein is shown for illustrative, informational purposes only. Any historical data used as a basis for this analysis are based on information gathered by T. Rowe Price and from third‑party sources and have not been independently verified. Forward‑looking statements speak only as of the date they are made, and T. Rowe Price assumes no duty to and does not undertake to update forward‑looking statements.