Corporate vs government bonds – a risk-return crossroad

The difference in yields between US corporate bonds and Treasury bonds – also known as credit spreads – has narrowed to its slimmest margin in 20 years since President Donald Trump’s tariff announcement in April.

Corporate bonds are tools for companies to raise debt, funded by investors. They are typically seen as riskier than government bonds because companies are seen as more likely to default on repayments as they lack the authority of a government to increase income if needed.

There are two types of corporate bonds which receive scores for their level of risk by independent rating agencies: investment grade bonds (less risky) and high yield bonds (more risky).

Given the nature of these bonds compared to government bonds, investors demand a higher return to compensate for the greater risk. But as the income from both types of bonds are converging as of late, concerns are growing about whether corporate bonds are worth the risk associated with them. Also, more broadly, investors are asking if corporate bond yields  are truly representative of the economic backdrop.

Credit spreads typically tighten during periods of economic strength. Spreads narrowed at the end of last year following growing optimism that inflation would maintain its downward trajectory, interest rates would continue to drop in 2025, and recession would be avoided.

This optimism was somewhat tainted following Trump’s ‘Liberation Day’, which raised concerns that inflation could spiral and caused uncertainty around the future of the global economy. But with deals being agreed between many key trading partners coupled with the US economy remaining resilient, the impact of tariffs so far has not been as detrimental as initially thought.

A healthy jobs market and impressive earnings have improved the outlook for business activity and whetted the appetite of corporate bond investors, resulting in increased demand which meant yields fell (prices rose), and credit spreads narrowed.

What has also increased the demand for corporate bonds, investment grade in particular, are their low default rates in recent years. Investors aren’t having to accept significantly more risk within their strategies for the increase in fixed income. 

It’s been a volatile year for US government bonds for several reasons. Firstly, growing national debt has raised concerns over the viability of the Treasury market, as President Trump announced plans to increase spending without raising sufficient taxes. This resulted in ratings agency Moody’s downgrading Treasuries from Aaa to Aa1 in May – the last of the major ratings agencies to do so.

Secondly, tariffs have played a role in disrupting the US Federal Reserve’s (Fed) roadmap for cutting interest rates this year. Coming into 2025, markets expected the Fed to continue its rate cutting cycle. However, the unknown impact of tariffs halted the central bank from reducing its base rate until further economic data gave evidence that inflation was still trending down, towards the Fed’s 2% target.

Inflation has ticked up slightly in recent months and the US economy has remained resilient, justifying the Fed’s decision to pause any interest rate changes. However, much of the drivers for this uptick in inflation are likely transitory, and tariffs have not caused the economy to overheat just yet. Therefore, Fed Chair Jerome Powell recently signalled that the central bank would likely resume its rate cutting cycle in September.

Hope of a resumption to interest rate cuts caused yields for both corporate and government bonds to fall, but the recent optimism in the corporate sector sparked increased demand for the riskier option, which narrowed credit spreads. 

While our Anchor and Cycle process favours equities and alternatives in the current environment, bonds still provide diversification and return benefits for investors.

The chart below shows that the ‘real yield’ – the 10-year US government bond yield adjusted for inflation – is at its highest level since before the global financial crisis. This highlights the income government bonds could offer in a portfolio despite the risks presented by growing government debt and sticky inflation.

We maintain a robust allocation to government bonds which have seen an adjustment in yields over recent years, offering investors positive real yields and ballast against global growth shocks. 

Due to tight credit spreads we maintain a conservative exposure to corporate bonds, favouring higher quality investment grade names where low defaults can still see positive returns at expensive valuations.

The value of investments, and the income from them, can fall as well as rise and you may not get back what you put in. Past performance should not be taken as a guide to future performance. You should continue to hold cash for your short-term needs.