Are structural spread changes concealing value in credit?

Credit spreads across many fixed income sectors have returned to historically tight levels in late summer. This observation is most acute for U.S. corporates—both investment grade and sub-investment grade—where spreads are near the tightest levels since the turn of the 21st century. This is after widening in the wake of the Trump administration’s initial tariff announcements in early April.

What are the implications? At first glance, it would appear that corporate bonds offer limited value and compensation for bearing credit risk.

But what if we’re not comparing apples to apples? Could unique aspects of the current environment justify such historically tight spreads? Could credit spreads tighten even beyond the current historically tighter levels? This is probably one of the most contentious discussions within our team at the moment. We have some portfolio managers who are making a value‑based decision and underweighting some areas of credit, while others are simply leaning on the momentum and enjoying the ride (albeit nervously).

I discussed this dilemma with Portfolio Manager Anna Dreyer. She’s been researching this question with fixed income colleagues to provide a framework around these dynamics and their implications for relative value in credit.

How do the higher all‑in yields available on corporate bonds affect credit spreads?

Examining over three decades of U.S. corporate bond returns, we have found that higher all‑in yields beget tighter credit spreads. Unsurprisingly, higher current yields lead to higher forward returns on average in fixed income.¹ Investors, therefore, demand lower compensation in the form of tighter credit spreads when all‑in yields are higher.²

This observation holds for fixed income investors in general. However, higher yields offer an additional advantage to insurance investors. Because these buyers account for their investments at book value rather than market value, higher current yields—especially when in excess of the average book value—increase insurance demand and drive spreads lower. Unsurprisingly, insurance companies account for an increasing share of the demand for U.S. investment‑grade corporate bonds over the last 10 years.

U.S. and euro‑area investment‑grade corporate bonds have also gained popularity among non‑U.S. investors, especially those in Asia. Yields in many Asian markets—notably Japan—are lower than yields in the U.S. or Europe. Subsequently, institutional investors in Asia have become an important marginal buyer of U.S. and eurozone corporate credit in the last several years. This demand can also drive credit spreads tighter, again assuming investors perceive that the higher yields are sustainable and credit risk remains contained.

It’s also important to keep in mind that non‑U.S. investors are taking on currency risk when they buy U.S. corporates. As a result, a weaker U.S. dollar could cause a reallocation away from U.S. debt, dampening this source of demand.

What about credit demand from an asset allocation perspective?

Asset allocators frequently compare cross‑asset yields when making portfolio allocation decisions. The yield on U.S. high yield bonds,³ for example, currently exceeds the S&P 500 Index’s earnings yield⁴ by almost three percentage points. Equity volatility has dwarfed that of high yield bonds historically, so the combination of superior yield, meaningfully lower volatility, and potentially lower downside has been drawing investors into the non-investment‑grade credit market, tightening spreads.

In fact, current yields of U.S. investment‑grade corporates,⁵ especially for intermediate and long maturities, also exceed the earnings yield of the S&P 500 Index, driving investment‑grade corporate spreads lower as well.

Does a supply/demand imbalance play a role?

Absolutely! Broadly, the demand for fixed income assets exceeds supply. For example, assets in money market investments are at historically high levels. These assets are potentially available for redeployment into high‑quality credit and potentially longer‑duration bonds, particularly as the Treasury yield curve has steepened.

According to Federal Reserve data, the net worth of the U.S. private sector was USD 218.6 trillion as of March 31, 2025, which was approximately seven times the size of the investment‑grade fixed income benchmark index.⁶ In addition, the U.S. fixed income market generates at least USD 1.6 trillion of annual coupon payments that need to be reinvested. For the first time in over a decade, the historically large size of these coupon payments exceeds the total net supply of U.S. fixed income credit. This supply/demand imbalance is yet another factor driving credit spreads lower.

How have broad credit quality trends within U.S. high yield credit influenced spreads?

The overall credit quality of U.S. high yield corporate credit indexes has improved considerably over the last 10 to 15 years. About one‑third of the U.S. non‑investment-grade bond market is now secured. In another indication of higher credit quality, 62% of the Credit Suisse High Yield Index had BB credit ratings (the highest sub-investment grade rating category from S&P Global Ratings) as of June 30, 2025, up from only 37% in 2007. This naturally translates into tighter credit spreads.

Implications for historical spread comparisons

In summary, comparisons of today’s credit spread levels with historical levels should consider these fundamental causes of tighter spreads. While current corporate spread levels appear historically tight, especially in the U.S., these structural drivers could conceivably and rationally drive them even tighter.

We also need to remember that the “risk‑free” asset (government bonds) that we measure spreads against has generally deteriorated in credit quality as governments have expanded their fiscal deficits. Consequently, credit may offer more relative value than current spread levels ostensibly suggest, so credit could deserve a larger allocation in a diversified asset allocation portfolio.