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The U.S. economy is looking resilient based on recent data, but cracks are starting to show for certain companies – and that could be bad news for investors chasing yield. Earlier this week, the Commerce Department reported that U.S. gross domestic product for the second quarter grew 3%, surpassing the 2.3% estimate from economists polled by Dow Jones and reversing a 0.5% decline in the previous quarter. Nevertheless, companies with less-than-sterling ratings are feeling some pressure, according to data from Moody’s Ratings. More downgrades at the lower end of the speculative grade spectrum lifted the rating agency’s “B3 negative and lower” list to 241 companies as of the end of June. That’s up from 225 companies a quarter earlier. Investment grade companies have Moody’s ratings that range from triple-A to Baa3. Below that threshold, companies with ratings ranging from Ba1 to C are deemed non-investment grade. These names offer higher yields on their bonds, but they also face higher default risk. “Volatile market and tougher credit conditions exacerbated defaults in Q2, with defaults outnumbering upgrades off of the list by almost four times,” wrote Moody’s senior analyst Julia Chursin in the July 17 report. She noted that default risk for certain consumer-facing sectors has also increased in light of slowing consumer spending and tariff-related costs. For fixed income investors, this means that quality should take a priority over rich yields – and it’s time to resist the urge to go dumpster diving into the most speculative corners of the market. “In general, we have a higher quality bias at this point in time,” said Sam Millette, director of fixed income at broker-dealer Commonwealth Financial Network. “Investment grade corporate spreads are relatively tight, but on an absolute level, their single-digit yield is still compelling.” When spreads are tight, that means the difference between the yield you’re getting for a corporate bond versus what you get for a comparable government bond is shrinking. “You might not be getting compensated in the high yield space adequately for the risk you’re taking there,” Millette added. The prospect of higher for longer rates On Wednesday, Federal Reserve Chair Jerome Powell dashed the markets’ hopes for a September rate cut when he said the policy-setting Federal Open Market Committee hasn’t reached a decision for how it will proceed at the next meeting. He also said that higher tariffs “overall effects on economic activity and inflation remain to be seen,” suggesting more data will need to come in before policymakers move forward. But the silver lining there is that it doesn’t take much to pick up portfolio income. “Jay Powell and the Fed are going slower and keeping yields higher longer – that’s a good thing for bond investors,” said Mary Ellen Stanek, president of Baird Funds and a portfolio manager on Baird’s Core Plus Bond Fund (BCOIX) . “But we also acknowledge to investors that spreads are relatively tight. … In this asset class, we don’t try to hit home runs because you’re not paid to take that kind of risk,” she added. Seeking opportunities Plenty of companies still have solid fundamentals, said Andrew O’Connell, senior investment analyst at Baird. “Companies are remaining in solid place fundamentally, balance sheets are still healthy, and margins are above pre-Covid levels,” he said. “To the extent we see some deterioration in the economy, with the uncertainty – that could happen, but [the companies] are coming at it from a strong level and there is some overall cushion to deal with that,” he said. Corners of the fixed income market O’Connell likes include the insurance sector and banks. “We continue to find value in financials,” he said. “It fundamentally lines up with what we are looking for. Financials are trading a bit behind industrials, but they still have more room to run. We think the banks are in an outstanding position.” He also noted that while the company is focused on credit quality, Triple B-rated issues can still offer some value – for those who are willing to do the homework. “That’s where we devote the time and resources to do the research and understand specific industries and companies,” O’Connell said. “Not all triple-Bs are created equal.” Elsewhere in the fixed income world, Commonwealth’s Millette said that financial advisors at his firm have been more focused on the core-plus sector – in which funds invest largely in investment-grade issues with some flexibility to add some exposure to high yield and bank loans – rather than merely reaching for yield. Municipal bonds are another area of the fixed income world that still offers attractive yields, particularly for high-income investors, Millette said. Income from these bonds is tax free on the federal level, and it may be free of state taxes if the investor resides in the issuing state. “Traditional investment-grade munis have done a better job of building up rainy day funds,” he added. “The fundamentals are strong and valuations are compelling on a historical basis. Given their relative underperformance this year, they can be poised to perform a little bit better in the second half.”
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