Midyear U.S. Credit Outlook: Why Investors Should Be Selective

Summary

Thoughts on the Market: Midyear U.S. Credit Outlook – Why Investors Should Be Selective

Release Date: June 4, 2025
Host: Morgan Stanley

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Introduction

In the June 4, 2025 episode of Thoughts on the Market, Morgan Stanley's experts Andrew Sheats, Head of Corporate Credit Research, and Vishwas Patkar, Head of US Credit Strategy, delve into the midyear outlook for U.S. credit markets. This episode marks the beginning of a series examining global credit perspectives, with a particular focus on the United States. The discussion centers on the economic backdrop, creditworthiness of U.S. corporates, optimal investment segments, and potential future scenarios affecting the credit landscape.

Economic Backdrop and Its Impact on Credit Markets

Andrew Sheats opens the conversation by setting the stage for the discussion, highlighting the recent update to Morgan Stanley's 12-month outlook for global credit markets, with an emphasis on the U.S. Vishwas Patkar outlines the central economic scenario shaping the credit outlook:

“Our central scenario of slowing growth, somewhat firm inflation and no rate cuts from the Fed until the first quarter of 2026... I view that as somewhat mixed for credit. It's good for certain segments of the market, not as good for others.”
— Vishwas Patkar [00:39]

Patkar explains that the current environment presents both opportunities and challenges for the credit market. On the positive side, the de-escalation in trade tensions has reduced recession risks, enhancing the stability of credit markets. Additionally, the attractive yields available across the credit spectrum are compelling for investors. However, the anticipated slowdown in economic activity poses a significant downside, deviating from the previously favorable conditions experienced in the latter half of the previous year.

“We’re certainly not in the Goldilocks environment that we saw for credit through the second half of last year. And it's important here for investors to be selective around what they invest in within the credit market.”
— Vishwas Patkar [01:48]

Creditworthiness of U.S. Corporates

Andrew Sheats transitions the discussion to the core of the credit market: corporate lending. He raises concerns about the creditworthiness of U.S. corporations, especially in light of prolonged higher interest rates.

“Credit is an asset class that's ultimately about lending to companies. And so how do you see the creditworthiness of US corporates and how much of a risk is there that with interest rates staying higher for longer than we expected at the start of the year, that becomes a bigger problem?”
— Andrew Sheats [02:19]

Vishwas Patkar responds by emphasizing the importance of focusing on the underlying credit health of corporations rather than being swayed by market volatility and headline news. He asserts that the current corporate balance sheets are robust, attributing this resilience to several factors:

• Controlled Credit Market Growth: Limited credit market expansion in recent years has prevented excessive leverage.
• Muted M&A Activity: Reduced mergers and acquisitions signify a cautious approach among corporations.
• High Interest Rates: Persistent higher rates have curtailed overleveraging and speculative growth.

“Broadly, health of corporate balance sheets is pretty good. And in some ways, I think it's maybe a more distinguishing feature of this cycle where corporate credit overall is on a firmer footing going into a period of slower growth than what we may have seen in prior instances.”
— Vishwas Patkar [03:10]

Patkar further explains that the heightened interest rates, while posing challenges, have also dampened aggressive borrowing, thereby reducing the sensitivity of credit markets to economic slowdowns. He cautions, however, that credit markets are not immune to severe economic downturns, but the current fundamentals provide a buffer against extreme adverse scenarios.

“If we get a recession, spread should be a fair bit wider. But I think in our central scenario, it makes us more confident than otherwise that credit overall can hold up.”
— Vishwas Patkar [03:40]

Regarding the risk of sustained higher interest rates, Patkar differentiates between various segments of the credit market. High-quality credits benefit from strong demand and sponsorship from institutional investors like insurance companies and pension funds. Conversely, lower-tier credits with higher leverage and elevated debt costs face increased default risks under prolonged high-rate conditions.

Optimal and Challenging Segments in U.S. Credit

Andrew Sheats probes further into which segments of the U.S. credit market currently offer the best and worst risk-adjusted returns.

“What would be a segment of US Credit that you think offers some of the best risk adjusted return at the moment? And what do you think offers some of the worst?”
— Andrew Sheats [04:35]

Vishwas Patkar categorizes the credit outlook as favorable for quality investments while being unfavorable for higher-beta, riskier credits:

• Best Opportunities:

  • Investment Grade (IG) Credit: Anticipated double-digit total returns with modest outperformance compared to government bonds.

    “We’re calling for double digit total returns in IG. We also expect investment grade credit to modestly outperform government bonds.”
    — Vishwas Patkar [04:35]

  • Upper-Tier High Yield (e.g., BBBs): These segments are expected to benefit from similar positive trends as IG credits.

• Challenging Segments:

  • Lower-Tier High Yield (e.g., CCCs and Single Bs): Elevated leverage and high debt costs make these segments more vulnerable in a slowing growth environment.

    “Where leverage is fairly elevated, debt costs are still high. We think this is still a challenging environment where growth is set to slow and rate cuts are still a fair bit out of forecast rise.”
    — Vishwas Patkar [05:25]

Alternative Scenarios: Best and Worst-Case Outcomes

Concluding the discussion, Andrew Sheats invites Vishwas Patkar to explore potential deviations from the central scenario and their implications for the credit market.

“In our view, what do you think are the realistically better and worse scenarios for US Credit this year and how does that shape your overall view on the market?”
— Andrew Sheats [05:38]

Better Scenario:

Patkar outlines a more optimistic outlook where further reductions in tariffs and improving economic indicators mirror the positive trends of late 2024. This scenario could lead to narrower credit spreads, akin to those observed in December, enhancing returns for investment-grade credits.

“Potentially revolve around tariffs being rolled back even further and... a combination of good growth and declining inflation and rate cuts moving up versus our expectations.”
— Vishwas Patkar [05:45]

Worse Scenario:

Conversely, a more pessimistic scenario involves a significantly slower economy or a recession. In such cases, credit spreads could widen, reflecting increased default risks. However, Patkar notes that due to the current strong fundamentals, even in a downturn, spreads may not reach the extreme levels seen in past bear markets.

“If we are being too optimistic about growth and what if the economy is set to slow much further and what if we get a recession?... spreads even in this downside scenario may not test the types of levels that we've seen through prior bear markets.”
— Vishwas Patkar [06:22]

Conclusion

The episode of Thoughts on the Market provides a comprehensive overview of the current state and future prospects of the U.S. credit market. Morgan Stanley’s outlook underscores the importance of selectivity in investment strategies, favoring high-quality credits amidst a backdrop of slowing economic growth and sustained higher interest rates. While the central scenario presents a mixed outlook, the underlying strength of corporate balance sheets offers resilience against potential economic headwinds. Investors are advised to navigate the credit landscape with a focus on quality segments to optimize risk-adjusted returns.

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Transcript

[A]

Welcome to Thoughts on the Market. I'm Andrew Sheats, head of Corporate Credit Research at Morgan Stanley.

[B]

And I'm Vishwas Patkar, Head of US Credit Strategy at Morgan Stanley.

[A]

Today on the program we're going to have the first in a series of conversations covering our outlook for credit around the world. It's Wednesday, June 4th at 2pm in.

[B]

London, at 9am in New York.

[A]

Vishwas along with many of our colleagues at Morgan Stanley, we recently updated our 12 month outlook for credit markets around the world, focusing on your specialty, the U.S. how do you read the economic backdrop and what do you think it means for credit at a high level?

[B]

So our central scenario of slowing growth, somewhat firm inflation and no rate cuts from the fed until the first quarter of 2026, when I put all of that together, I view that as somewhat mixed for credit. It's good for certain segments of the market, not as good for others. I think the positive on the one side is that with the recent de escalation in trade tens recession risks have gone lower and that's reflected in our economists view as well. I think for an asset class like credit, avoiding that real downside tail I think is important. The other positive in the market today is that the level of all in yields you can get across the credit spectrum is very compelling on many different measures. The negative is that we're still looking at a fair bit of slowing in economic activity and that's a big downshift from where we what we've been used to in the past few years. So I would say we're certainly not in the Goldilocks environment that we saw for credit through the second half of last year. And it's important here for investors to be selective around what they invest in within the credit market.

[A]

So Vishwas, you kind of alluded to this, but 2025 has been a year that so far has been dominated by a lot of these large kind of macro questions around what's going to happen with tariffs, big moves in interest rates, big moves in the US dollar. But credit is an asset class that's ultimately about lending to companies. And so how do you see the credit worthiness of US corporates and how much of a risk is there that with interest rates staying higher for longer than we expected at the start of the year, that becomes a bigger problem?

[B]

Yeah, sure. I think it's a very important question Andrew, because I think taking a call on markets based on the gyrations in headlines is very but in some ways I think this question of the Credit worthiness of US Companies is more important and I think it really helps us filter the signal from the noise that we've seen in markets so far this year. I would say broadly health of corporate balance sheets is pretty good. And in some ways I think it's maybe a more distinguishing feature of this cycle where corporate credit overall is on a firmer footing going into a period of slower growth than what we may have seen in prior instances. And you can sort of look at this balance sheet health along a few different lines in aggregate. We haven't really seen credit markets grow a lot in the last few years. M and A activity, which is usually a harbinger of corporate aggression, has also been fairly muted. In absolute terms. Corporate balance sheet leverage has not grown. And I think we've been in this high interest rate environment which has kept some of these animal spirits at bay. Now what this means is that the level of sensitivity of credit markets to a slowdown in the economy is somewhat lower. It does not mean that credit markets can remain immune no matter what happens to the economy. I think it's clear if we get a recession spread should be a fair bit wider. But I think in our central scenario it makes us more confident than otherwise that credit overall can hold up. Okay, now your question around the risk of rates staying higher. This I think goes back to my point about where in the credit market you're looking. I think up the quality spectrum. I think there are actually there's a lot of demand tailwinds for credit given the pickup in sponsorship we've seen from insurance companies and pension funds in this cycle. At the other end of the quality spectrum, if you're looking at highly levered capital structures, that's where I think the risk of interest rates being high can lead to defaults being sort of around average levels and higher than they would otherwise be.

[A]

So Vishwas, kind of sticking with that central scenario kind of briefly, what would be a segment of US Credit that you think offers some of the best risk adjusted return at the moment? And what do you think offers some of the worst?

[B]

Yep. So we framed our credit outlook as being good for quality, bad for beta. So as that suggests, I think this is a fairly good environment for investment grade credit. In our base case we're calling for double digit total returns in ig. We also expect investment grade credit to modestly outperform government bonds. And I would sort of extend that to the upper tiers within the high yield market as well, specifically bbbs. And where I would say risk reward looks the weakest is the lowest tier. So for triple Cs and for many segments within single Bs where leverage is fairly elevated, debt costs are still high. We think this is still a challenging environment where growth is set to slow and rate cuts are still a fair bit out of forecast rise.

[A]

So far we focused on that central scenario, but let's close out with how things could be different. In our view, what do you think are the realistically better and worse scenarios for US Credit this year and how does that shape your overall view on the market?

[B]

So I think the better scenario for credit versus our base case potentially revolve around tariffs being rolled back even further and it's essentially a repeat of the second half of 2024 when you had a combination of good growth and declining inflation and rate cuts moving up versus our expectations. I think in that scenario it's likely that you see investment grade credit spreads go back to the tights that we saw in December. On the flip side, I think the worst scenario really is what if we are being too optimistic about growth and what if the economy is set to slow much further and what if we get a recession? So I think in that environment we see spreads retesting the wides that we saw through the volatility in April. Although even here I would draw an important nuance that because of some of the fundamental and technical tailwinds I discussed earlier, we think spreads even in this downside scenario may not test the types of levels that we've seen through prior bear markets.

[A]

Vishwas, thanks for taking the time to talk. Thanks Andrew, and thanks for sharing a few minutes of your day with us. If you enjoy thoughts of the market, let us know by leaving a review wherever you listen and tell a friend or colleague about us today.

[C]

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