Schroders: In Q1, the resilience of U.S. high-yield bonds is highlighted, but tariffs and stagflation risks exacerbate market differentiation

According to the Zhitong Finance APP, Schroders stated that in the first quarter, the U.S. high-yield bond market showed resilience, not experiencing the severe decline that was expected amid broader economic uncertainty. Although the absolute return of this asset class was positive, it still did not generate excess returns above the risk-free rate, as the return on the high-yield bond market was 113 basis points lower than that of duration-neutral U.S. Treasuries. A clear bifurcation emerged in the high-yield bond space: BB-rated bonds outperformed lower-rated bonds. This result reflects investors' shift towards higher-quality bond categories in response to economic uncertainty.

Schroders pointed out that the first quarter of 2025 is becoming an increasingly complex period for global fixed-income investors, influenced by factors such as geopolitical realignments, changes in trade policies, and evolving monetary expectations. The Trump administration's decision to implement a new round of U.S. tariffs was the most direct catalyst for volatility in the investment market. Although the formal announcement of the tariff increase was made at the beginning of the second quarter (April 2), prior warnings had already been issued, and market concerns had persisted for several weeks. The scale of the tariffs announced on "Liberation Day" still surprised many.

From a macroeconomic perspective, the impacts of these policies are multifaceted. Tariffs impose direct cost impacts on importers and consumers while also exerting downstream pressure on investment decisions and supply chain configurations. Estimates from the International Monetary Fund (IMF) indicate that if the average tariff rate increases to the announced levels, the U.S. Gross Domestic Product (GDP) for the entire year of 2025 will decrease by 0.9%, and the inflation rate will rise by 1%. This outcome could increase the risk of stagflation, a troubling environment characterized by weak economic growth and high inflation.

The performance of U.S. Treasuries in the first quarter of 2025 still reflects growing investor concerns about deteriorating economic growth prospects and an increased interest in safe-haven assets. As market volatility increased in March, U.S. Treasury yields significantly retreated. In the first quarter, the yield on 5-year Treasuries fell by 43 basis points to 3.95%, while the yield on 10-year Treasuries dropped by 36 basis points to 4.20%.

U.S. labor market indicators are sending mixed signals. Overall initial claims for unemployment benefits remain stable, but targeted layoffs are increasing, particularly in industries heavily reliant on U.S. federal government spending or cross-border goods transportation. Preliminary expectations suggest that some laid-off federal government employees will be absorbed by the private sector, with the unemployment rate projected to reach 4.5%. However, confidence among small businesses continues to erode. The National Federation of Independent Business (NFIB) small business optimism index fell from 105.1 in December 2024 to 97.4 in March 2025. Given that small businesses account for about 50% of all jobs in the U.S., the rise in pessimism raises concerns about the U.S. employment outlook.

Meanwhile, the Federal Reserve is taking a wait-and-see approach, temporarily keeping the policy interest rate unchanged while indicating that it will closely monitor economic data and respond as necessary. The Fed's median dot plot indicates that there will be 2.5 rate cuts in 2025, with only about 2 rate cuts in 2026, leading to a terminal federal funds rate of 3.0%. However, expectations in the investment market have already changed at the beginning of the second quarter of 2025. The current consensus is that if inflation remains high while economic growth declines, there will be three rate cuts by the end of 2025 and only one rate cut in 2026 If uncertainty persists and tariffs significantly slow down global trade, the likelihood of stagflation increases.

In the cautiously optimistic investment market atmosphere of the first quarter of 2025, the investment-grade corporate bond market also reflects an increasing sense of unease. At the beginning of 2025, fixed income credit spreads were at a historically tight level of 80 basis points, which slightly widened to 93 basis points by the end of the first quarter. Nevertheless, the spreads remain within a neutral range, as they neither reflect widespread market distress nor indicate that valuations are attractive enough to justify taking on risk. Although spreads have widened due to tariff-related market uncertainties, they are still below the long-term median of 123 basis points and the average of 145 basis points.

The U.S. earnings results for the fourth quarter of 2024 show that corporate fundamentals provide a layer of assurance for investors at these tight spread levels. These results indicate an average year-over-year stable growth of 3.5% in earnings before interest, taxes, depreciation, and amortization (EBITDA) compared to the same period in 2023. The average interest coverage ratio also reached a solid 9.3 times. These data suggest that while the overall U.S. corporate sector has not thrived, it still possesses enough resilience to withstand a mild economic downturn. Capital expenditures recorded an 11% year-over-year growth in the fourth quarter of 2024, but as companies face potential turbulence in tariff negotiations between the U.S. and other countries, capital expenditures are expected to stabilize. In the long term, as domestic suppliers for U.S. companies increase, spending may see a faster rise. However, for now, all eyes are on how suppliers, customers, and manufacturers digest tariffs.

Schroders is also closely monitoring the dynamics of investor demand for U.S. investment-grade corporate bonds, particularly the potential impact from investors outside the U.S. If U.S. Treasury yields remain stable, and corporate bond spreads widen slightly, U.S. investment-grade bonds may become increasingly attractive to overseas investors seeking high-quality, dollar-denominated income sources. Increased demand from outside the U.S. should help boost the prices of investment-grade corporate bonds.

Despite the challenges posed by rising interest rates and tariff-related uncertainties, the high-yield bond market continues to be supported by favorable technical factors. The bond default rate is suppressed, and the refinancing calendar, also known as the "maturity wall," has been pushed back, with many bonds now maturing as late as 2029. These factors provide a buffer for the high-yield bond market, especially in a scenario where U.S. economic growth slows but does not collapse.

The securitized bond market remains known for its complexity and return dispersion. By the end of the first quarter of 2025, interest rates fluctuated again due to expectations regarding U.S. tariffs. This affected the overall performance of mortgage-backed securities (MBS) and asset-backed securities (ABS) In the asset-backed securities sector, Schroders prefers high-quality auto loan structures. Despite rising concerns about consumers' ability to repay loans, this structure remains robust. Subprime borrowers, particularly among younger demographics, have higher default rates, but the market for high-quality AAA-rated asset-backed securities is still well protected by structural enhancements and underwriting.

Compared to corporate bonds, Schroders still prefers to invest in mortgage-backed securities due to their higher yields and quality. However, if the spreads on investment-grade corporate bonds continue to widen, especially in the event of an economic downturn, fund managers may begin to shift from mortgages to higher-yielding corporate credit. This shift could put mid-term spread pressure on mortgage-backed securities. Nevertheless, the increased demand from banks for high-quality assets that can provide additional yield may help offset potential capital outflows from the mortgage-backed securities market. Meanwhile, lower yields may trigger an increase in early mortgage repayments from homeowners, a development that will further complicate investors' risk-return trade-offs in institutional mortgage-backed securities