Investment grade outlook: Balancing opportunity and risk

From AI-fueled tech earnings and tightening credit spreads to anticipated Federal Reserve rate cuts and evolving risk positioning, here’s how we’re navigating the bond market in August.

Craig: We've seen a bit of a bifurcation in earnings with strong showings from the technology sector while more traditional sectors have lagged. What are you seeing from different sectors from an earnings perspective?

Todd: Tech earnings have been very strong, led by the Magnificent 7 (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla), driven by their capital expenditures into artificial intelligence (AI).¹ It's estimated that about $2 to $3 trillion is going to be spent on AI over the next couple of years.² With that level of capital expenditure, there are going to be secondary and tertiary positive effects for the economy. On the other side, some of the lower end, consumer cyclical companies are seeing a little bit more pressure due to slowed consumer spending. For bank earnings, for example, asset quality is still favorable, and systematic risks appear to be negligible.

The bottom line is we see solid consumer balance sheets, supportive corporate balance sheets, and positive tailwinds for the economy from tech. But there are also some laggards and that's how we're positioning the portfolio. We're cautious on the lagging sectors and are positioning accordingly.

Craig: Spreads, or valuations, are optically rich. Are there reasons why they may continue to grind tighter?

Todd: While spreads are tight, yields are still very attractive on a historical basis.³ Whether it’s institutional or retail investors, people are buying some of the best yields that you’ve been able to get over the last 15 years.⁴

Additionally, we believe the health of the US Corporate Bond index, with a higher credit quality and lower duration than historical periods, is better than it has ever been.⁵ The combination of elevated yields, a healthy corporate index, and robust liquidity can paint the picture of why spreads may go tighter.

Craig: We saw a couple of big merger and acquisition (M&A) deals in July, one of which was Union Pacific acquiring Norfolk Southern. Was that a debt-funded deal and potentially a harbinger of more M&A to come?

Todd: One of the biggest concerns we had at the beginning of the year was late-stage M&A or shareholder-friendly activities that would be detrimental to bondholders. We didn’t see much of that due to the volatility surrounding Liberation Day. In these environments, people want to protect their balance sheets as well as their capital-protected liquidity. As credit spreads have gone tighter, we’ve seen more deal activity but, in our view, it's been more strategic in nature. We've been monitoring it but haven’t seen activities that are unfriendly to bondholders.

Craig: Year-to-date bond market performance has been strong, but valuations are still a bit tight. Volatility from higher inflation and tariff noise continues to persist. How have you synthesized that into portfolio construction and risk modulation?

Todd: We’ve oscillated risk a bit up and down. At the start of the year, we were more constructive on the growth outlook. Going into Liberation Day, we reduced risk due to elevated volatility. Since then, we’ve added risk back into the portfolios, though not to pre-Liberation Day levels. As spreads have continued to grind tighter, we’ve once again moved to lower overall risk levels. We believe there are still yield opportunities, so we’re overweight in higher-quality credit. We also see opportunities in the non-investment grade space. We’ve been buying collateralized mortgage-backed securities (CMBS) and asset-backed securities (ABS) deals linked to data centers with attractive yields, so there’s still a lot of idiosyncratic opportunities that make sense. I think we’ll trim a little more risk in August. Historically, September and October are a bit more volatile with a lot of new issue opportunities. It should serve us well to leave some dry powder on the table as we get into Fall.

Craig: We don’t typically take large bets on rates, but how are you positioned from a rate perspective?

Todd: We’re just a touch overweight on duration, about a quarter of a year, mostly in the short-end of the yield curve, while neutral on the long-end of the yield curve. Our view is that if we see negative economic data, we want to be positioned for it. We believe the short-end rates ultimately lead the curve lower and steeper.

Craig: Do you expect to see cuts by the Federal Reserve (Fed) this year? What’s your team’s view on the rate outlook?

Todd: Labor data and unemployment have been some of the sticking points for why the Fed did not want to cut rates. With the weaker employment data released on August 1, we believe there’s a clearer path to start cutting. We think we’ll get a rate cut in September with the potential for additional cuts before the year end. Even if rate cuts don’t materialize, the market is starting to look through to the end of Fed Chairman Jerome Powell’s term and what that means. Whether it happens during Powell’s term or the next, we think the future path of the policy rate is lower.