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

Release Date: June 4, 2025
Host: Morgan Stanley

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.

For those seeking deeper insights into the credit markets and strategic investment approaches, subscribing to Morgan Stanley’s Thoughts on the Market podcast is highly recommended.