Slowdown in Fed cuts would keep corporate bond spreads muted

US corporate bond spreads are hovering at a multiyear low that may be sustained as the Federal Reserve weighs a potential slowdown in the pace of its rate cuts.

The option-adjusted spread in the 10-year S&P 500 investment-grade corporate bond index dropped to its lowest point since it was launched in 2015, at 67 basis points (bps) on Oct. 17. The spread for the 10-year S&P US high-yield corporate bond index touched a six-year low of 276 bps on Oct. 17 and Oct. 21. The spreads measure the difference in premiums paid to investors in corporate debt rather than government debt.

Spreads have been on a downward trajectory since March 2023 when the Fed neared the end of a hiking cycle that brought its benchmark interest rate to a 20-year high. While the central bank enacted its first cut in September and is likely to reduce rates further at its next meeting Nov. 6–7, an expected slowdown in the pace of cuts should keep spreads from rising materially above their current lows.

"A slower pace of rate cuts could keep spreads low for a prolonged period of time," said Collin Martin, director and fixed-income strategist for the Schwab Center for Financial Research. "A slower pace of rate cuts would likely be the result of a stronger-than-expected economy. Although corporations might not get the benefit of significantly lower borrowing costs, the strong economy would likely mean higher profits and cash flows to service their debts."

Inflation and economic growth

The Fed began its interest rate easing cycle in September with a 50 bps cut, which some observers felt was too aggressive considering a backdrop of favorable economic indicators. Markets are now pricing in expectations that the Fed will approach further cuts more cautiously.

"About 65 basis points of cuts by the US Federal Reserve are priced in by January 2025, down from over 100 basis points shortly after mid-September's initial cut," said Ken Wattret, vice president of global economics for S&P Global Market Intelligence, in an Oct. 15 report.

Corporate bond yields and spreads are not directly linked to interest rate decisions, but they are influenced by macroeconomic conditions such as economic growth and inflation that guide the Fed's monetary policy.

"If the pace of Fed cuts in 2025 slows from current market expectations, it could be because growth is more robust than anticipated or inflation ticks higher," said John Gentry, senior portfolio manager and head of the corporate fixed-income group at Federated Hermes. "Stronger growth would be good for corporate spreads, while inflation may or may not be good, depending on what drives it higher."

Recent spread compression has more likely been caused by stronger employment data rather than the Fed's actions, though market volatility and healthy corporate profitability have also had an impact, Gentry said.

Some economic indicators present contradictory perspectives, with certain factors having an outsized influence on bond activity.

"Despite a slowing economy, corporate spreads remain compressed due to persistent inflation," said Althea Spinozzi, head of fixed-income strategy at Saxo Bank.

Investor approach to tight spreads

Though corporate bond yields are down in 2024 compared to 2023 levels, they remain at high levels that are historically attractive for investment. The yield-to-maturity of the 10-year S&P 500 investment-grade corporate bond index — the overall rate paid to an investor who holds a bond to maturity — has stayed above 5% for most of 2024. However, tight spreads with the US 10-year Treasury note still pose risk for investors.

"Investors are seeking to hedge against inflation and potential surprises in monetary policy by locking in additional spread over their benchmark," Spinozzi said.

Investors are also considering a change in bond investment strategy while interest rates remain elevated, with some now shifting their focus away from short-term bonds and toward longer duration debt opportunities at attractive yields that will benefit over time amid a declining rate environment, said Dana Burns, senior portfolio manager of investment-grade fixed income at PineBridge Investments.

"If the Fed disappoints the market and cuts fewer times due to a stronger economy in which inflation is manageable, we think it would still support credit spreads as it would likely portend healthier corporate fundamentals," Burns said.