Mitigating Risk in a Bond Portfolio: Why Valuation Discipline Matters

In equity markets, momentum investing can work even when valuations are high. Investment grade bonds are different. Core fixed income is meant to be the ballast in a portfolio, not a place to chase returns at any price. When spreads run very tight, valuation discipline becomes critical.

Where We Stand Today

- Investment grade corporate bond spreads are currently just 74 basis points.  We

haven't seen such levels since 1998 – leaving little room for further compression.

- While spreads can stay tight, the Fed’s shift to cutting rates reduces the coupons available in the market. 

- Tight spreads have recently been supported by higher coupons, so the move to easier monetary policy should reduce demand for credit as income generation declines.

The Risk of Reaching for Yield

Many managers, even in core bond categories, are moving down in credit quality to maintain yield. We believe this is not a responsible strategy for portfolios that are supposed to provide stability.  Stretching into lower-quality bonds when spreads are already compressed adds risk without providing commensurate reward.

This risk is compounded by persistent inflation pressures, including tariff-driven cost increases, and signs of consumer stress – we recently saw the largest decline in average FICO scores since the Global Financial Crisis. Together, these trends increase the vulnerability of lower-quality issuers at precisely the time many managers are adding exposure to them.

What Investors Should Ask

As the Fed cuts amid signs of labor market weakness, it’s worth asking: are your core fixed income allocations providing ballast, or are they quietly taking more risk to deliver the same yield?

Maintaining valuation discipline means resisting the urge to reach when markets are stretched. In our view, that’s the right way to mitigate risk in a bond portfolio.