Credit-backed investments have had a remarkable run this year in the face of (some) scary headlines about risk and leverage, record issuance and the move to higher interest rates.

They are not the best performing sector—that has been cash  (local government investment pool and money fund investments)—for short-term investors. But in each segment of the market investment grade corporate bonds have out-performed Treasuries and other fixed income investments.

  • For example, AAA-A corporate bonds with maturities of one to five years have had an annualized return of 1.47% through August 31 vs. an annualized return of 0.14% for comparable duration Treasuries.
  • Spreads—the difference between yields on corporates and Treasuries—have narrowed from 2025 levels, providing a boost to corporate bond returns.
  • Credit metrics such as the strength of corporate balance sheets and corporate earnings ratios have improved. Default ratios are low and the ratio of credit upgrades to downgrades by rating agencies is sharply positive.
  • The out-performance of credit-backed instruments has left little from here to compensate investors for taking credit risk in the current and next legs of the market. If spreads widen from the very narrow current levels these holdings will under-perform other sectors.  It’s a bit of a “be thankful for what you’ve earned but don’t count on the trend to continue.”

 

Charting the course of corporate bond returns illustrates the challenges with predicting the markets.  For example, one would think that record issuance of corporate debt this year and analyst forecasts of the enormous capital needs to fund artificial intelligence would cause investors to demand greater interest margins for committing their money to corporate bonds.

Indeed, in the first half of the year domestic issuance of investment grade corporate debt topped $1.5 trillion, up 30% over 2025.   Issuers also tapped the foreign markets at a notable pace, seeking new sources of capital with sales of Euro-denominated debt, largely to satisfy U.S. issuer demand, up nearly 50%.

One could also postulate that rising political instability would lead investors to disfavor corporate bonds in favor of Treasuries, with their low risk and higher liquidity.  This too should push spreads wider.  But both  theses were challenged by the recent performance of corporate bonds.

In the past year our model 1-3 year portfolio, representing a typical public funds investment portfolio (60% Treasuries, 30% A or better corporate bonds and 10% cash) returned 2.80%.  The corporate component returned 3.26% while Treasuries returned 2.46%.  Corporates yielded about seven basis points of extra return per month on average over the past 12 months.  For the three months ended August 31 the corporate allocation contributed an average of five basis points per month, but by last month the contribution had narrowed to four basis points.

That’s because spreads between Treasuries and corporate bonds narrowed over the year. They started the period at a modest level that contracted further during the year  to the current level.  As the below chart illustrates the spread  between investment grade corporate bonds and Treasuries maturing in one to three years is notably below its recent range and average.   Narrowing spreads meant that the incremental income available to be earned from corporate bond holdings (measured by yield to maturity) contracted, from 46 basis points  more than Treasuries 12 months ago to 32 basis points at the end of August.

Credit Market   Warnings Aside

Complacency might explain this.  Despite the wonders of Bloomberg in displaying historic information back to time zero at the touch of a few keys, investors sometimes seem to have short memories.  The last severe disruption of the credit markets was caused by the Covid-19 recession.  That could be written off as a one-time event.

Recent warnings by leading investors like Ray Dalio, founder of Bridgewater Associates, and Jeff Gundlach of DoubleLine Capital that the credit markets contained significant systemic risk have seemingly been discounted.  Dalio focused on what he saw as a sovereign debt crisis while Gundlach warned of cracks in the growing private credit market. While both aimed squarely at corporate credit, one would think these warnings would cause investors to pull back.  But this hasn’t happened.

Credit Metrics are Strong

Credit metrics related to the overall market are stable and improving. (It’s important to emphasize this is an overall measure and does not speak to the credit quality of an individual issuer.)  A Bloomberg analysis of cash flow available to pay debt shows a positive trend, with the ratio of earnings (EBITDA) to interest for investment grade corporate bonds rising from 9.4 times in 2024 to 12.1 times.  Meanwhile net debt  of the universe of investment grade bonds analyzed by Bloomberg is 3.1 times EBITDA, not much higher than it was two years ago (3.1 times).  Translation: Debt loads haven’t changed much despite the surge of issuance, while cash available to pay debt is up.

Credit ratings reflect this. The three main credit ratings agencies have consistently upgraded more investment grades than they have downgraded in recent years.  This year the combined ratio is 2.7 upgrades for every downgrade.

Finally, the cost to insure debt against defaults has been at or near historic lows all year.  At this writing it is 52 basis points, below the five-year average of 62.

Bottom Line

Corporate bonds have performed well this year despite warnings that they might not do so.  But the result is that they now offer a smaller income benefit compared with Treasuries.  The difference in yield to maturity for all short-term investment grade corporate bonds vs. Treasuries  is now 32 basis points.  If you allocated 30% of a portfolio to corporates that would add about ten basis points to the portfolio yield/return.

Whether the juice is worth the squeeze is a good question, and a complicated one. Much of the analysis here is based on the broad characteristics of  a basket of corporate bonds represented by an index or an ETF.  (The PFII model portfolio utilizes an ETF.)  This approach achieves a high level of diversification that is not achievable in a portfolio of separately-held securities, as the ETF contains several hundred issues with  no  issuer  likely to represent more than a half percent of the ETF’s  holdings.  This diversification offers an investor very strong protection against an issuer-specific credit event.

One could  seek added portfolio income by concentrating holdings in a few issuers, earning perhaps two or three times the 32 basis points of average  yield spread.   If you are highly confident of the issuer’s credit and have no concerns about possible default or “headline risk” concentrating holdings this could be a strategy, but it is not without its unique risks, especially if you are a public funds investor whose every act is in a fish bowl.