Even as sovereign bond yields were volatile over the past year, the spread between them and credit yields has tightened steadily. We cut global investment grade (IG) credit to underweight on a tactical, six- to 12-month horizon last September after preferring it over stocks and high yield since mid-2022. That change funds risk-taking in pockets of credit where the risks seem better compensated for. We favor high yield and stay neutral: Its yield is attractive and returns are less sensitive to interest-rate swings. Regional differences underpin why we prefer European credit overall. U.S. IG and high yield credit spreads are further below their 10-year average than European peers. See the chart. European spreads have underperformed since 2020 partly due to a different sector composition and weaker growth in Europe, in our view. Yet we think the excess yield in European credit compensates for the risks.
We see markets embracing a more supportive near-term macro outlook. In the U.S., we expect inflation to fall near the Fed’s 2% target this year before resurging beyond 2024. We went overweight U.S. stocks this year because we think the upbeat risk appetite can persist and broaden out beyond artificial intelligence, until resurgent inflation comes into view later this year. Robust U.S. growth, nearing Fed rate cuts and falling inflation have lessened the market’s recession worries. That’s good news for emerging market (EM) assets, in our view. We’re overweight EM hard currency debt – mostly denominated in U.S. dollars – as spreads look more fairly valued than U.S. high yield. We see broader credit spreads staying tight for now given the supportive risk-taking backdrop, and strong demand for new issuance of U.S. IG and U.S. high yield credit bonds.
Maturity costs
Yet we see a risk that could cause high yield spreads to widen as markets price in more credit risk. About 10% of the market value of euro area high yield debt is maturing in 2025, 6% of U.S. high yield debt – and even more the next year, BlackRock Aladdin data show. We find that’s not an exorbitant amount, and even the lowest-rated high yield issuers have been able to refinance debt this year. Still, refinancing at higher interest rates may challenge operating models that assumed rates would stay low, in our view. IG companies also have debt maturing, but we think their stronger balance sheets are more flexible.
A year after a few U.S. regional banks collapsed, we have seen the funding challenges higher interest rates create. We’re monitoring the impact of higher rates and maturing debt on commercial real estate. The sector will likely face more pain, but we think it will be manageable as the reset to lower valuations occurs over multiple years. We see a more supportive near-term macro backdrop. Firms that need to refinance may turn to private credit as banks cut back on lending. We prefer private market credit over public on a strategic horizon of five years and longer because we think demand will rise and higher yields better compensate for risk. Yet private markets are complex, with high risk and volatility, and aren’t suitable for all investors.
Our bottom line
We get granular as the near-term macro outlook improves the environment for risk-taking. We’re overweight U.S. stocks, euro area high yield and EM hard currency debt. We also see opportunities in private credit as public debt matures.
