Investment grade outlook: Insights for October

The Federal Reserve (Fed) cut interest rates, Treasury rates moved higher, and financial markets reacted in ways that seemed counterintuitive. Plus, demand for investment grade remained strong despite yields coming down. What does it mean for investment grade bonds and the economy? We tackle these topics and more in our Q&A on how we’re navigating the bond market in October.

Craig: The 25-basis point (bps) rate cut in September was largely as expected, yet Treasury rates moved higher across the yield curve. Why did rates respond this way?

Matt: Rates can be volatile whenever the Fed shifts policy. The market starts focusing on what’s next, both for the path of cuts as well as what the cuts mean for the growth of the economy and inflation expectations. It’s currently pricing about one less rate cut by the end of 2026 than what the expectations were before the September Fed meeting.¹

Craig: Some Federal Open Market Committee (FOMC) members and economists have made the case for continued or even faster cuts, while others have argued for a more patient approach. Assuming Chairman Jerome Powell will be replaced by someone more dovish when his term expires next May, is this what the market should be pricing?

Todd: Even if the next Fed Chair is inclined to take rates lower, to gain FOMC support, the argument for lower rates must still be justified by the economic situation. Also, the Fed controls the front end of the curve, but as you saw, even the 2-year yield rose after the Fed cut. The market is going to move the curve, and if the Fed is doing something that the market perceives will, for example, be inflationary, rates may react adversely.

Craig: Matt, you’ve generally been fairly optimistic on the US economy this year. Headlines and forecasts throughout the year, however, have been gloomy at times due to tariffs, consumer confidence, the labor market, and other concerns. Do you still think the economy is on a good footing?

Matt: We’ve seen upward revisions to gross domestic product (GDP), solid corporate earnings, and continued projections for large capital expenditures from the tech sector related to artificial intelligence (AI). Plus, companies have been rewarded in the stock market. While you may hear about headwinds for the economy, however, that’s not what’s reflected in asset prices. So, while I’m positive on the economy, I’m not suggesting loading up on risky assets.

Fortunately, high-grade bonds are well-positioned to perform in a range of economic outcomes. With valuations the way they are, we don’t see value in trying to pick up the last bit of incremental yield. For the reasons I just mentioned, we’re also not getting overly defensive. It’s also why we think the Fed can continue to cut even though the economy looks OK. Since rates are still restrictive, there are still risks that could knock the economy off course.

Craig: Financial markets reacted in ways that seemed counterintuitive in September. Are we back to the world of “good news is bad news” and the market is all about whether or not the Fed cuts?

Todd: That’s what it felt like in the short term. I don’t think the economy is desperate for Fed support. But markets may want cuts, especially when valuations are stretched. Still, I think good news is good news… unless it’s too good and vice versa. We don’t want to discount what the market is telling us, but I think some of those oscillations are mostly about uncertainty, which we’ve had plenty of this year. If those reactions get too far away from our view, then they’re potentially buying or selling opportunities for us.

Craig: Let’s talk about performance. The Bloomberg US Aggregate Bond Index was up 1.09%² over the past month, and the Bloomberg US Corporate Bond Index was up 1.50%.³ You’ve noted valuations are tight, so how were you able to navigate this market?

Matt: You mentioned earlier that rates backed up after the Fed cut, but they’re actually lower on the month, and spreads are also tighter. We’ve been slightly long on duration, particularly on the front end. We’ve also been overweight credit risk, given the positive views we’ve discussed. We’re really just staying the course on that view. Earning positive carry has been the key. At the same time, because of tight valuations, we’re running low tracking error — or active risk — relative to history.

Craig: Yields recently touched year-to-date lows of around 4.25% on the Bloomberg US Aggregate Bond Index and 4.65% on the Bloomberg Corporate Bond Index.⁴ We’ve talked all year about how the steady demand from yield-focused buyers has supported the investment grade market. Has that bid for bonds started to fade as yields have come down?

Todd: No, we’ve had more than $1 trillion of issuance year-to-date,⁵ and yet market demand continues to be very strong. Last month, we had one of the largest new issues of the year — $18 billion from one of the large tech companies.⁶ It was more than four times oversubscribed. New issue discounts are razor-thin and spreads remain tight — all signs that demand continues to outstrip supply. While we may be past peak yields in investment grade, yields are still attractive relative to history. There’s also a fear of missing out on yields now that the Fed is cutting, which tends to drive increased demand. You’ll probably continue to see that as the curve steepens and investors who’ve been parked in cash can’t get the yields they’ve become accustomed to without buying longer-dated bonds.