Government vs corporate bonds: what’s the outlook?

While it’s been a mixed picture, demand for corporate bonds has been steady due to low default rates and attractive all-in yields. Meanwhile credit spreads, the credit risk premium paid over government bonds, has reduced. 

This complex and varied bag, along with heightened geopolitical and macroeconomic uncertainty, has brought some common questions to the fore. 

Oliver Faizallah, Charles Stanley’s Head of Fixed Income Research, sums up what’s been happening and how taking a ‘barbell approach’ has helped investment professionals navigate today’s global bond market.

This article is for authorised intermediaries and professional investors only. 

Government vs corporate bonds: what’s the outlook?

Credit spreads across investment grade (IG) and high yield (HY) corporate bonds have been tight for the past couple of years. This has reflected healthier corporate balance sheets, but in our view also highlights investor complacency and optimism around default risk. In both the US and Europe, spreads have been near cycle lows, with European credit appearing marginally more attractive given its lower proportion of cyclical companies. 

Fundamentals remain strong: corporate balance sheets are robust, liquidity is ample, and the proportion of higher quality BB-rated issuers in HY markets has increased significantly, suggesting improved credit quality. 

Yet, this strength may mask underlying risks.

In the US, signs of labour market softening and cyclical weakness could expose vulnerabilities, particularly if unemployment rises and consumer demand falters. In private credit markets, concerns around misallocation of capital and opaque risk structures have highlighted a tail risk that could spill over into public markets.

Developed market government bonds have been pricing in fiscal and political risks. Longer-dated UK gilts, for example, have been carrying a meaningful term premium (an additional spread to short-dated gilts), reflecting investor caution around debt sustainability. France’s widening government bond (OAT) spreads relative to other European government bonds have also highlighted political instability and fiscal concerns. The US is facing entrenched deficits and rising interest payments and with limited scope for fiscal reform. Meanwhile, while US Treasury yields are elevated, we believe they could push slightly higher.

Are corporate bonds expensive and government bonds cheap?

While corporate bond spreads are expensive relative to history, ‘all-in’ yields have remained attractive, which is why investors have continued to buy them. 

To take advantage of high all-in yields while avoiding drawdowns from credit spread widening, we have preferred short-term corporate bonds. Longer-dated corporate bonds don’t offer much additional spread compensation. However, the amount that credit spreads would need to widen for the yield received to fall to zero (the ‘break-even’) is smaller than it is for short-dated credit. Therefore, shorter-term corporate bonds could perform better if spreads rise, so they’re considered a more defensive option.

Government bonds, by contrast, have offered higher term premiums, especially in the UK and France where fiscal and political risks are more front of mind. Longer-dated government bond yields could be considered a good way to ‘add back’ the duration risk taken away by investing in shorter-dated corporate bonds. 

UK gilts yields have risen due to shifts in fiscal concerns as well as demand and supply dynamics. While French government bond yields have been reflecting political instability and widening deficits. It could be argued that because these factors are reflected in a higher term premium, government bonds have been more fairly priced than corporate credit. 

Are high debt levels a dealbreaker?

Debt above 100% of GDP has historically been a line in the sand indicating a country could be seen as a risky investment. The reality is more nuanced. Many economies operate above this level without signs of stress, while others have faced crises at much lower debt ratios.

Government bond valuations are influenced by debt levels, but are also driven by expectations around growth, inflation, policy rates, and many other macroeconomic factors. 

UK: inflation remains elevated but is falling, while the Bank of England’s tighter policy stance has pushed real yields higher. Concerns over the UKs high debt levels, growing deficit, and difficult choices ahead at the Autumn Budget have led to a steep term premium. As such, yields appear fairly priced in our view and reflect the UK’s fiscal challenges and structural market shifts, including reduced demand from pension funds.

France: acute political uncertainty and widening deficits have led to a credit rating downgrade and a sharp rise in term premiums. French OATs now yield significantly more than German Bunds, reflecting investor caution.

US: inflation remains sticky but is easing, and the labour market is softening, however growth appears robust. Short-term rates may be pricing in too many cuts, while real yields have fallen. If fiscal reform remains elusive, or inflation remains higher for longer, short-end rates and term premiums could rise.

Overall, while tight spreads in corporate credit suggest expensive valuations, the broader yield environment, especially in government bonds reflects a more nuanced pricing of macro and fiscal risks.

How should investors get exposure?

In Charles Stanley’s Fixed Income Research team, we favour a barbell strategy, combining short-term corporate bonds with longer-term (~10-year) government bonds. 

It helps us manage two key risks separately: credit spread widening and interest rate risk (changes in bond yields).  

In recent times, short-duration corporate bonds have been offering lower volatility as well as better protection if credit spreads widen. Although shorter duration credit will be defensive in a spread widening environment, we still wish to hold interest rate duration to mitigate portfolio drawdowns during stress. Therefore, we add this back, using longer-dated government bonds, resulting in short-duration credit risk and longer duration interest rate risk.