Fortune Favors the Disciplined: The Margin for Error Remains Low

Fixed-income markets are pricing too much perfection, so investors should favor duration, higher-quality credit and security-specific relative value over a broad reach for yield.

• Defaults on bonds issued in 2023–2025 and the overall annual default rate have been below average, but the authors argue that credit cycles inevitably turn and that recent tranquility should not be extrapolated.
• U.S. consumer delinquencies, consumer and business bankruptcies, and the Economic Policy Uncertainty Index have risen, while credit spreads have tightened instead of widening as they historically have during periods of greater uncertainty.
• Credit spreads are near historic lows across the quality spectrum, making lower-grade securities unattractive on a risk-reward basis despite the persistence of nominal yields that are higher than those seen for much of the past 20 years.
• The Treasury yield curve is steeper than it has been for two decades, and real yields on Treasurys and high-grade bonds are higher than during much of the past 20 years, allowing investors to obtain income without taking unnecessary credit risk.
• After more than 10 years of post-GFC monetary accommodation, central-bank intervention has receded since 2022, while inflation remains sticky and the market faces uncertainty over new Fed chair Kevin Warsh and the persistence of energy-price effects.

Takeaway: Investors should rebalance excess cash and equity risk toward the higher-quality yield curve, maintain duration selectively and wait for more normal credit spreads before increasing exposure to lower-quality bonds; taxable investors should also consider municipal bonds because their tax-equivalent yields remain attractive.