Strong Bond Market Catching Investors' Attention

MIKE TOWNSEND: There is plenty of excitement in the equity markets these days. Last week's historic IPO of SpaceX energized many retail investors. And with more big IPOs on the horizon, it would not be surprising to see similar enthusiasm. But hand in hand with these high-profile IPOs come increasing notes of caution. Volatility has picked up.

Earlier this month, the SP 500® declined 4.5% over just six trading days before bouncing back up. Market analysts have started using the "B" word, "bubble," in talking about the tech sector. And some analysts have started to raise concerns about a larger pullback. But amidst all the hubbub around equities, it's easy to miss that bonds are priced attractively right now and generally have far lower risk than some of the buzzy investments in the equities market.

When things are looking frothy, or perhaps poised for a correction, it can be a good time to take a look at the supposedly boring side of your portfolio. Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.

Coming up in just a few minutes, I want to dive into what's going on in the bond market with my colleague Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research. We'll sort through the recent inflation and jobs reports and what they mean for the economy, changes to watch for at the Fed as the Kevin Warsh era begins, why now might be the right time to consider adding some balance and stability to your portfolio with fixed income, and where to find opportunities that match your time horizon.

But before we get to that conversation, here are three things I'm watching in Washington right now. 

First up, on June 9, after months of delay and haggling, Republicans were finally able to pass a $70 billion bill that provides three years' worth of funding for Immigration and Customs Enforcement, better known as ICE, as well as Customs and Border Protection and other Homeland Security functions. 

Disputes over the funding were a key contributor to last fall's full government shutdown and this spring's 76-day shutdown of the Department of Homeland Security. In the end, Republicans were able to use the budget reconciliation process to pass the funding without a single Democrat in either the House or the Senate voting for it. But a bigger question that I'm interested in here is what this outcome does to the normal budget and appropriations process on Capitol Hill. Using the budget reconciliation process, which can be only used when one party controls the White House, the Senate, and the House, effectively bypassed the annual government funding process for these handful of agencies, which are now funded through September of 2029. That annual government funding process, in which a budget is agreed to, and then Congress appropriates specific funds to every federal agency and program, is broken.

Congress is supposed to pass the 12 appropriations bills by October 1 each year. That's the date the federal government's fiscal year begins. It has not done that since the 1990s. In recent years, there have been countless temporary funding measures and multiple government shutdowns when Congress could not even agree on a temporary measure. Now the precedent has been set to fund certain government operations outside of the process entirely.

And the president is calling on Republicans to pass another budget reconciliation bill to fund defense spending and other priorities. All this makes this year's budget process, which has barely begun and already devolved into fighting between the two parties, seem almost impossible. A temporary funding bill is expected this fall since neither party wants to shut down the government a few weeks before the midterm elections. But what happens after that is anyone's guess. And it's getting harder to believe that Congress will ever get the government funding process back on track. 

Second, last week there was a little-noticed confirmation hearing in the Senate for a position that matters deeply to the markets. The Senate Health, Education, Labor and Pensions Committee heard testimony from the president's nominee to be the new head of the Bureau of Labor Statistics, or BLS. That's the agency that produces critical economic data, including the monthly jobs report, key inflation measures like CPI, the Consumer Price Index, PPI, the Producer's Price Index, and more. The agency became the center of controversy last August when the president fired the former head of the BLS, Erica McEntarfer, after a jobs report included historically large revisions to previous months' data. 

The firing raised questions about whether the White House would pressure BLS to manipulate the data. But the president's nomination of Brett Matsumoto, a career economist who has been at the BLS since 2015 and is currently on leave while he works with the White House Council of Economic Advisors, seemed to calm concerns that the agency's independence could be compromised. At Matsumoto's hearing last week, he told senators that he was committed to the integrity of the agency's work. "I do agree that fulfilling the mission of the BLS to accurately measure economic data does require independence from political interference. And if confirmed, I fully commit to maintaining the integrity and independence of the BLS," Matsumoto said.

He also said that he did not believe previous data had been faked or manipulated. And he said that he would be focused on improving data collection. Citing in particular stemming the decline in employer responses to surveys on jobs, considering how best to incentivize more responses, and focusing on what alternative sources of data could be used to supplement the employer surveys. Matsumoto isn't across the finish line yet. He first needs to be approved by the committee and then confirmed by the full Senate, but that's expected to happen later this summer, and the markets are likely to be reassured by his testimony last week.

And third, we recently received the annual report of the trustees of the Social Security Trust Fund, which provides a detailed assessment of the program's finances. This new report estimates that without any congressional action to shore up the program, Social Security will be unable to pay out full benefits beginning in the last quarter of 2032. That's one quarter earlier than was projected in last year's report. The report estimated that the fund would only have enough money to pay 78% of benefits. The problem itself is not news. Everyone in Washington has known for decades that the math eventually would overtake the Social Security System, that the number of workers paying into the system is being outpaced by the number of beneficiaries taking money out of the system. Changing demographics are exacerbating the problem, as declining birth rates mean there are fewer workers paying in, and increasing lifespans mean that retired Baby Boomers are taking benefits for longer. 

But from a policy perspective, the problem has always seemed very distant, such that there wasn't much urgency for Congress to address it. Now, however, with this new projection, it means that the crisis will come during the term of the next president, and the pressure on Congress to address the crisis will grow. For members of Congress, the problem has long been that all of the policy options to shore up Social Security create politically painful votes. Those policy options include cutting benefits, raising the retirement age, raising the amount of income that is subject to the payroll tax, or increasing the payroll tax rate itself, to name a few. The latest projections from the Social Security trustees mean that those kinds of difficult choices will have to be faced sooner than expected. 

The report also provided an update on the Medicare Hospital Trust Fund, projecting that it would no longer be able to pay out full benefits beginning in the second quarter of 2033, if Congress doesn't make any changes to the program before then. That's slightly sooner than had been projected a year ago. The math problems plaguing Social Security and Medicare have long been seen by lawmakers as a looming problem, but one that remains safely at a distance, something for a future Congress to solve. Now that future Congress is in sight.

While I think it is unlikely that major steps will be taken between now and the 2028 presidential election, shoring up both Social Security and Medicare is likely to be among the most important policy challenges facing the next president when he or she takes office in 2029. 

On the last episode of WashingtonWise, we explored what's been going on in the equities market and whether it is sustainable. Since that episode, equities have seen some increased volatility. And whenever there's volatility on the equity side, that tends to heighten interest in the fixed income market as a potential source of stability. On my deeper dive today, I want to explore what's going on in the bond market and how investors should be thinking about using fixed income strategically in an environment that is more uncertain. To do that, I'm really grateful to be joined by my colleague Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research and co-host of our sister podcast On Investing. Collin, welcome back to WashingtonWise. Thanks so much for joining me.

COLLIN MARTIN: Hey, Mike, thanks for having me back.

MIKE: Well, Collin, let's get this conversation going with some numbers, specifically inflation numbers. Last week, the May numbers for the Consumer Price Index, CPI, were released, and they showed that inflation is continuing to creep upwards. That comes on the heels of a different measure of inflation at the end of May, the Personal Consumption Expenditures Price Index, which also showed elevated inflation. We'll get an update on that number next week. But walk us through these numbers and what they're telling us.

COLLIN: Well, inflation has actually been rising for the past few months now, but that doesn't tell the whole story because it's really been elevated for years. After peaking in 2022, the inflation rate has slowed, but the improvement sort of stalled out. We saw a lot of inflation indicators hovering in the 2.5 to 3% area since 2024. And now inflation is rising again. But lately it's been driven by higher energy prices given the conflict in the Middle East.

So the CPI release for May showed that inflation rose by 0.5% for the month and 4.2% on a year-over-year basis. And that was its highest 12-month reading in more than three years. Much of that increase came from energy prices, though, which rose 3.9% for the month. Now, if we look under the hood, core CPI rose by just 0.2%. And that was sort of a silver lining in the report. Let's dig into those differences a little bit, since there's a number of ways to look at inflation. 

Headline inflation includes all prices; it's comprehensive. And then core inflation excludes food and energy prices since they tend to be a bit more volatile. The Fed prefers core inflation because that's an area where monetary policy can actually have an impact. If you look at the recent increase in headline inflation, much of it is driven by higher oil and gas prices. The Fed can't do much to fix that.

The Fed can't magically allow oil tankers safe passage through the Strait of Hormuz. That's why the Fed prefers core inflation readings. It can't directly impact food or energy prices, but its policy can impact consumers and businesses alike and can alter our spending habits. Core inflation tends to focus more on the demand side of the equation rather than the supply side.

And the Fed will likely focus on core inflation readings going forward to see if the higher energy prices we've seen will flow into the prices of other goods and services.

MIKE: Great explanation of CPI, but there's another measure of inflation that the Fed prefers even more than that.

COLLIN:  Yeah, that's right. It's called the PCE, the Personal Consumption Expenditures Index. The Fed prefers PCE for a few reasons. One, it has a dynamic weighting process, meaning it changes its basket weights each month to better reflect actual spending habits. Two, it has a broader scope. The PCE includes spending made on behalf of households, like Medicare and Medicaid and employer-paid health insurance. And then three, there's different weights.

Housing makes up 33% of the CPI, but just 15% of the PCE. And healthcare has a lower weight in the CPI than it does in the PCE. And there's really no right or wrong inflation indicator,Mike. Actually, there's no shortage of inflation indicators out there. It's not just the CPI or the PCE, but when we look at these two specifically, the Fed thinks the PCE is a bit more indicative of how U.S. consumers are actually spending their money.

MIKE: On top of inflation, the other big number that we've been looking at recently is jobs. And we got the most recent jobs report, which showed that 172,000 new jobs were added in May. Plus, there were some upward revisions to the previous couple of months' numbers. So taken together, labor market appears pretty stable. In that sense then, you've got kind of competing tensions when it comes to the Fed's dual mandate of maximum employment and price stability.

But it seems like the focus is and should be on the price stability side of that equation, which means the goal is bringing inflation down. And leading that effort is Kevin Warsh, the new chair at the Federal Reserve. He was handpicked for the job by President Trump, who was very vocal about Jerome Powell not doing enough to bring interest rates down quickly. But Warsh is taking the reins in a very different environment than when he was nominated back in January.

At that time, the markets were pricing in as many as three rate cuts before the end of 2026. Now, not only do those cuts appear to be off the table, but it looks like we're going to be in the "higher for longer" phase, with the Fed leaving rates steady until later in the year, maybe the very end of the year, maybe not even until next year. And interestingly, financial markets have been hovering around a 70 to 80% chance of a rate hike by the end of the year.

Does that seem about right to you?

COLLIN: That chance, or implied probability, seems a little bit too high for me, mainly because the outlook today is really very uncertain given everything that's going on in the Middle East. We expect the Fed to be in wait-and-see mode. Our base case is that the Fed remains on an extended pause for now, holding its benchmark interest rate steady through the end of the year, meaning no hikes or cuts. And as you mentioned that implied probability of a hike has been increasing, with a hike fully priced in by the first quarter of next year, but we're really not there yet. In a vacuum, the case can be made for the next move to being a hike. Inflation has generally held above the Fed's 2% target for over five years, and now it's moving in the wrong direction. And the labor market has actually strengthened a bit over the last few months.

I think the key question is will those trends be sustainable? On the inflation front, it's possible that the worst is behind us since the price of oil has actually declined a bit lately, and remember, inflation measures the rate of change, not the price level itself. I think the Fed needs a clear reason to hike, but right now there don't appear to be strong enough reasons.

While inflation has risen, inflation expectations remain relatively well anchored. And while the labor market has improved over the past few months, I think officials would likely need to see that continue on a more sustained basis.

MIKE: Yeah, it's going to be a tricky time and really interesting time, obviously, for Kevin Warsh to be coming on to the chair's seat. Fed watchers, I think, are going to be paying really close attention to his approach to leading the Fed. Obviously, as chair, he sets things up. He runs the meetings. He's the one to share the committee's decisions. But overall, he is just one of 19 voices on the FOMC, twelve of whom vote on monetary policy decisions, so he can't just dictate what happens. 

One of the more interesting things to me as Warsh settles in is that he has been pretty clear that he wants to change how the Fed communicates to investors and the markets. He is on record saying that he thinks the Fed overcommunicates. He is not committed to holding a press conference after each FOMC meeting, which is something that Jerome Powell started doing back in 2019. 

He's also been very clear about how much he dislikes the Fed's dot plot. That's the graph the Fed releases four times a year that captures where the 19 members of the FOMC expect short-term interest rates to be over the next couple of years. His view is that when those forward projections are published, policymakers will hold on to those positions even if the economy shifts. And that given the propensity of the economic data to change, projecting out where things will be in a couple of years from now just isn't that useful. 

Now, obviously, Warsh has been on the job for just a few weeks at this point, so he's not making any big decisions on these kinds of things right away. But there's a lot of discussion in the financial world about what it will mean if Warsh limits how much is shared about what went into making the latest decisions on Fed policy. 

So Collin, is that something for investors to be concerned about? Or is it just the case that the market sort of adapts to the personality and style of each Fed chair and ultimately this won't be that big of a deal?

COLLIN: I think it's somewhere in between. It could result in some short term volatility as we get used to a potentially new communications process. It's important to remember that a lot of the things that Warsh is not necessarily a fan of haven't always been around. Press conferences after the FOMC meeting only began in 2011, and at first, they followed every other meeting. And then, as you mentioned before, Mike, it wasn't until 2019 that they began to follow every meeting. 

And then the dot plot, which is something that Warsh has focused on a lot, something that he noticeably dislikes, that was only introduced in 2012. And I think communications is an area where Warsh might be able to influence the other policymakers and kind of put a stamp as chair there. 

Now I think there can be pros and cons to the more frequent communications that we get from Fed officials, as well as the dot plot itself, because together they can give investors an idea of what the various committee members are paying attention to. Each speech or interview by a committee member can provide some insights into how he or she is viewing the economy, the inflation outlook, the labor market outlook. Without those sort of insights, there could be somewhat large jumps in short-term yields when we get an important data release. If we don't have guidance from those Fed officials about how they are thinking about the economy, and let's say we get a surprising data release, market volatility could increase as investors might not really have a clear idea about how the Fed might respond to that. Now, I do think the risk of higher volatility could decline over time, though, as the market gets a better understanding of how the Fed may work going forward with less communication.

MIKE: Well, as I said, not a big dramatic change in communications right away, but definitely something that we're going to be watching over the remainder of this year as Kevin Warsh settles into that chair seat. 

I want to go back to the inflation discussion for a moment because you said something that stuck with me, and that was this idea that there are other inflation measures besides just CPI and PCE. 

And there is one that is on the table now because Kevin Warsh has talked about an alternative measure of inflation known as the trimmed mean. And that filters out the most extreme price moves. His argument is that it'll give a better picture of where actual inflation stands because a lot of those extreme price moves are shocks to a specific part of the economy. But the flip-side is that if those shocks tend to be ongoing and not just one-offs, then this trimmed mean gauge could understate real pressures impacting the economy. What are your thoughts on this and what seems to be the current thinking at the FOMC on embracing this kind of change?

COLLIN: Well, I think there's pros and cons to an approach that focuses on trimmed-mean inflation readings. Since it excludes extreme price movements, both the highest and the lowest, it can isolate the real trend in inflation. So that can be a good thing. Now, one of the more popular trimmed-mean inflation indexes is the Dallas Fed's trimmed-mean PCE. And in April it rose by just 2.35% on a year-over-year basis. And if we look at that compared to the other inflation indicators we were talking about before, headline and core CPI or PCE, that reading of the trimmed mean is a little bit lower. And again, taking it at face value supports the case for the Fed to take a patient approach and maybe not see a need to hike rates in the face of the higher inflation readings we've seen recently.

But there are potential cons, there are potential downsides, and there can be situations where trimmed-mean inflation readings actually understate the inflation trend. Noticeably, importantly, Dallas Fed President Lorie Logan thinks that's a risk today. That's important because it's her district that puts the index out. I think that adds a little bit more weight to it if she's saying, hey, this index might understate it, and it actually comes from my district. If she's saying that, I'm listening to that.

Now consider today's environment where energy prices have been rising sharply and other goods and services have been rising a bit more moderately. If you trim out a lot of those large energy increases, the declines or the low readings that you're trimming out on the bottom aren't moving as far in an extreme direction. And that could help understate it as well.

Now you asked about potential buy-in from the Fed and are they embracing this change? I don't think it's going to be a factor or an indicator that that they use as a primary policy driver going forward. It might be one more tool in the toolkit, one more indicator they pay attention to, but I don't think it will be the inflation driver that they focus on. 

MIKE: Well, as we think about the Fed, it's important to remember that the Fed controls the very short-term fed funds rate, but ultimately, it's buyers who control interest rates on Treasuries. Last week we had a three-year, a 10-year, and a long-dated Treasury auction, and buyers didn't seem to shy away from demanding greater yields.

COLLIN: No, they didn't. And when we look at Treasury auctions, they can be important as they give us information about those supply-demand dynamics and especially what the demand is for our government's debt. The Treasury has regularly scheduled auctions. It auctions Treasury bills, which are those that mature in 12 months or less, very frequently. Those are usually auctioned weekly. And then Treasuries with longer maturities are auctioned a bit less frequently, usually monthly.

And for each auction, there are a handful of indicators that we look at to gauge if it was a strong or a weak auction. One of those indicators is the bid-to-cover ratio. It's the amount of bids placed relative to the size of the auction. So if you have a large number there, a lot of bids relative to the size of the auction, that's a good thing. That means there's a lot of people interested in participating in the auction.

We look at the high yield. That's the yield that is offered after the security gets auctioned. It's what the yield of the issue is after the auction. And then we also look at the stop through or the tail. And this ties into that high yield before. It's how much higher or lower that high yield is relative to where the issue was or the previous issue was trading in the secondary market. So for example, let's say a 10-year Treasury is being auctioned, and the most recent 10-year Treasury yield is 4% in the secondary market, and then, after this auction for a new one, if it's auctioned at 4.01%, or one basis point higher, that would be a tail of one basis point. That's a sign of slightly weaker demand as investors are demanding higher yields than what's offered in the secondary market prior to the auction.

Now, all of these factors matter when determining if an auction is weak or strong. A lot of times, Mike, I hear about the risk of a failed auction, which to me would mean there actually aren't enough buyers to take down the whole auction. That hasn't happened in history. There hasn't been a failed Treasury auction. And we look at all these factors as a sign of demand because it can pose a risk to Treasury yields, because if demand is weak, yields might need to move a little bit higher to attract that marginal buyer. Now, the good news is demand still appears to be relatively strong. You mentioned last week's auction. The one that we focus on the most is usually the 10-year Treasury yield auction. That tends to be a global benchmark. That auction went relatively well. The bid-to-cover ratio was a bit higher than the previous 10-year Treasury auction. And then the high yield was actually a little bit lower than where the 10-year was trading pre-auction. Both of those were signs of relatively strong demand.

MIKE: That's interesting. That's something that comes up in Washington all the time because there's a lot of discussion given the scale and scope of the government debt, whether there'll be enough buyers for our debt. And there's always a question about whether China will continue buying our debt or Japan or another country will. But that's good to know that those auctions are remaining strong.

Well, I wanted to talk about some of these more specific types of options in the fixed income market. And one of the areas that I've been seeing investors really plowing a lot of cash into is short-dated bond funds, specifically ultra-short bond funds, those that generally mature in less than a year. So far this year, more money has flowed into them than any other Morningstar fixed income ETF category. What's the appeal of these ultra shorts?

COLLIN: Ultra-short bond investments can have benefits. You mentioned they generally have maturities of less than a year. So given their very short-term nature, they don't have much interest rate risk, meaning their prices are less sensitive to changes in interest rates compared to slightly longer term bonds. And the yields they offer are generally well above levels we saw in the decade plus coming out of the financial crisis.

The yields offered on ultra-short bond investments tend to be somewhat correlated to the fed funds rate. And the fed funds rate today is in the 3.5% to 3.75% range, again, well above levels from 2010 through 2021. So they can offer relatively attractive yields and relative price stability. There's an opportunity cost, though, to holding these ultra-short investments—the cost of earning potentially higher yields elsewhere. And if we look at slightly longer-term maturities, whether it's short, intermediate, or long, they're incrementally higher. And the yield curve is positively sloped. The yield curve is really just a line that compares the yields of Treasuries of various maturities. So really from start with a three-month Treasury bill out to a 30-year Treasury bond, it's positively sloped. As you move out to slightly longer maturities, you're rewarded with slightly higher yields.

So if you look at a three-month Treasury bill, for example, it has a yield of somewhere in the 3.6% to 3.7% area. If you want to move a little bit longer in maturity to, say, a two-year Treasury, that two-year Treasury offers a yield a little bit above 4%. And then a five-year Treasury note today offers a yield near 4.2%. So there's slightly higher yields and more income that can be earned if you consider slightly longer-term maturities.

Now there can be a place in portfolios for short-term investments, but we think it's important that they be part of a plan. Most financial plans look years ahead, not necessarily months ahead. And the yields on ultra-short investments, again, they're highly correlated to the fed funds rate. So they can go up or down over short periods of time. Where if you have a longer-term plan, you might want to consider slightly longer maturities to offer a more predictable sort of income.

When you're thinking about short-term investments, also, I think there's kind of a bucketing approach you want to think about. Think about your everyday spending needs. That'd be your day-to-day cash. Then maybe think about what other sort of liquidity needs you have, maybe living expenses for the next handful of months. And when you fill out those buckets, if you then still hold a lot of these very short-term investments, you might be missing out on potentially higher yields elsewhere.

MIKE: That's a great analysis—appreciate that. 

Let's look at foreign bond markets and the impact that they can have on U.S. rates. Last week, the European Central Bank became the first major central bank to raise rates in this cycle. What are you watching on the global markets, and how much impact can they have on our rates?

COLLIN: They can have an impact on our rates, Mike, because we live in a global market, and the yields offered across the globe influence decisions, whether it's domestically or abroad. And if we think about, here in the U.S., we expect the Fed to remain on an extended pause, but you mentioned the European Central Bank raised rates. It's possible they raise again by the end of the year. The Bank of England is expected to raise rates. 

Unlike the Fed, that has a dual mandate of price stability and maximum employment, the ECB has one mandate, price stability. So it focuses more on inflation. Also, the Bank of Japan has gradually been raising rates over the past few years. So that can kind of put upward pressure on other developed-market government bonds, given that hiking bias.

And if we see global bond yields stay elevated or maybe even rise further, that might put some sort of floor under U.S. Treasury yields. Because if you're an investor, again, either domestically or abroad, and you find value elsewhere and maybe in another country, that could take demand away from the U.S., potentially keeping our yields elevated. 

Now, one thing to watch is who owns Treasuries. There has been concern that foreign central banks have been cutting the amount of our debt they were buying and holding, but that really hasn't happened. Foreign central banks and governments have actually kept their holdings at about the same level for about 15 years. Now it goes up and down on a monthly basis, but it's been relatively stable. The issue is that their holdings haven't really kept pace with our debt growth.

The good news is that other investors have, specifically foreign private investors, they've stepped in to pick up the slack. That is a potential risk. It's a potential concern because private investors, whether it's foreign or domestic, we tend to be a little bit more price and yield sensitive than a central bank. So if you're a foreign private investor, and you suddenly see better value at home or somewhere else abroad relative to what they can get with U.S. Treasuries, they might sell their Treasuries to buy something that that they find more attractive. And again, that means that maybe yields need to stay a little bit elevated, maybe stay higher for longer, to keep attracting new buyers.

MIKE: Well, let's continue our little tour around the fixed income markets. Corporate bonds, they're a big topic lately. AI companies in particular appear to be driving a lot of that. Until recently, artificial intelligence companies were doing a lot of self-funding to support their huge capex spending, but now they're raising capital through issuing bonds. On the equity side, there are concerns about AI stocks in terms of pricing and valuations.

But what about their bond offerings and what investors get for taking on greater risk here? And of course, with all the focus that's been on AI companies, it can be easy for other strong companies that are looking to raise capital to kind of get lost in the shuffle. So what's the broader outlook for corporate bonds? Where are you seeing value?

COLLIN: We do still see value in corporate bonds. We think their yields appear attractive, but the extra yield they offer above comparable Treasuries, the so-called spread, they are pretty low. Now we still find corporate bonds attractive despite the low spreads, because those spreads are low for a reason. The economy has been resilient, and corporate earnings have been pretty strong. And those low spreads suggest that investors don't really appear to be too worried about widespread default risk right now and aren't demanding significantly higher yields for that risk down the road. Now, just because that's the case today, it doesn't mean that default risk has disappeared, of course. It's just the way the markets are kind of pricing it. Default risk is always a potential risk when you're considering investing in corporate bonds. 

When we look at the investment grade corporate bond market, what we think are attractive are the yields they offer. The average yield of the Bloomberg U.S. Corporate Bond Index is back above 5%. And I've met with a lot of clients over the years, a lot of investors. We know that 5% is a level that people tend to be drawn to. You mentioned all the AI issuance, that's something that we've been focusing on, but when we look at the broad corporate fundamentals of the corporate investment grade corporate bond market, they still appear relatively strong.

And we look at the broad sectors and issuers; we think strong earnings and strong balance sheets still support the case to consider investment grade corporates today. We also see some value in high-yield corporate bonds. And for similar reasons, we think the yields are attractive. The average yield of the Bloomberg U.S. Corporate High-Yield Bond Index is near 7%. Spreads are low there as well, but we think a lot of the low spread comes from the improving credit quality of the index. The high-yield market, it's also called the sub-investment grade market or junk bonds. Those are bonds with ratings of BB or below. And BB-rated issues make up 56% of the index. So the bulk of the holdings in that Bloomberg U.S. Corporate High-Yield Bond Index have ratings at the high end of that high-yield rating spectrum. So we think that's a good thing.

There are risks, of course. I mentioned defaults before. While in today's environment the outlook seems relatively stable, when you invest with low spreads, there's just not much room for error if the economic outlook were to deteriorate or if defaults that I just mentioned were to pick up. If earnings growth slowed, investors might get a little bit worried about the prospects of repayment, or they might get worried about potential credit rating downgrades. And that could pull their prices lower in the secondary market as new investors demand higher yields to lend to those businesses.

MIKE: Last stop, municipal bonds. With Washington pushing a lot of financial responsibility back onto the states, how are state and local government offerings looking these days?

COLLIN: Well, broadly speaking, municipalities are no longer benefiting from the extraordinary fiscal tailwinds that followed the pandemic, but they still remain solid overall. State reserve levels are still elevated by historical standards. Revenue growth remains above its long-term trend. And importantly, we were talking about defaults before. Defaults for investment grade municipal bonds remain exceptionally low over long periods.

Now, that doesn't mean that all sectors are equally healthy, but at a broad market level, municipal credit remains pretty stable in our view. State and local balance sheets are not as flush with cash as they were at the peak of the post-pandemic strength, but they're still healthy. Reserve levels remain elevated. Most states continue to show disciplined budgeting, and revenue growth is above its long-term average. Now that said, investors shouldn't confuse a stable market level credit outlook with uniform strength across all sectors. Dispersion is rising. In a market where the broad tide is no longer lifting every issuer, security selection matters. 

Essential service sectors and many high-grade state and local issuers still look fundamentally resilient, and we think they appear relatively attractive for investors. But we do see some risks with other sectors like higher education and healthcare. Hospitals continue to face reimbursement pressure, labor cost inflation, and affordability challenges. And higher-education issuers remain highly uneven, with flagship public systems generally in much better shape than smaller tuition-dependent institutions. So this supports the case for issuer selectivity when it comes to these kind of riskier sectors.

MIKE: Well, that's a great overview, although I am still trying to get my brain around the concept that "states" and "disciplined budgeting" can be used in the same sentence. Collin, as we wrap up this conversation, which I've really found interesting, as we think about the volatility levels that we're experiencing right now in the stock market, it makes sense that a lot of investors are showing interest in bonds.

But as you've been laying out for us, bonds are not without their risks. So why don't you give us a quick roundup of opportunities from the most risk-averse to more risk and how you think fixed income investors should be thinking about opportunities?

COLLIN: Yeah, I like how you framed it kind of across the risk spectrum. So let me first focus on some of the more risk-averse investors. We still think high-quality bonds with short- and intermediate-term maturities make sense. I want to reiterate the points I made before that there's an opportunity cost to just focusing on ultra-short investments. Treasury yields are in the 4% to 4.5% area when you look at two- through 10-year maturities. And that's still higher than what you really could have gotten for many years after the financial crisis. 

If you're willing to take a little bit more risk, investment grade corporates appear attractive. They have those investment grade credit ratings for a reason. And we think their balance sheets appear healthy on average. Going even further down the risk spectrum, if you're willing to take even more risk, we think investors can consider high-yield bonds and preferred securities in moderation, of course. 

I mentioned high-yield bonds earlier, but preferred securities can make sense as well. If you're not familiar with preferreds, they are hybrid investments that share characteristics of both stocks and bonds. They come with unique risks, but they offer higher yields to compensate for those risks. And they also may provide tax benefits depending on the specific issue. I want to highlight that that not all preferred securities provide those tax benefits. So you always want to do your homework. Now for both high-yield bonds and preferred securities, be prepared for potential price fluctuations. If the economic outlook deteriorates, fixed income investments with more credit risk could see their prices decline in the secondary market more than higher-rated investments. And kind of summing it all up and looking broadly at the bond market, for most bond investments, we highlight that returns through the end of the year are more likely to be driven by income than price appreciation. But that's not necessarily a bad thing though. Over time, income payments tend to be the key driver of bond returns, not price appreciation.

MIKE: Well, super helpful perspective as always, Collin. Really enjoyed this conversation. Thanks so much for making the time to talk today.

COLLIN: You're welcome, Mike. Thanks for having me back.

MIKE: That's Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research. You can find Collin's writing on schwab.com/learn, and don't miss On Investing, the weekly podcast he co-hosts with Liz Ann Sonders.

Well, that's all for this week's episode of WashingtonWise. We're going to take a little break, so there won't be an episode in two weeks due to the July 4 holiday. We'll be back on July 16 for our next episode. Take a moment now to follow the show in your listening app so you get an alert when that episode drops and you don't miss any future episodes. And don't forget to leave us a rating or a review. Those really help new listeners discover the show.

For important disclosures, see the show notes or schwab.com/WashingtonWise, where you can also find a transcript. I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.