This article was first published in the Globe and Mail on April 26, 2025. It is being republished with permission.

by Tom Bradley

When I was a young stock analyst, I was always amused when my bond friends referred to themselves as the senior market. Unfortunately (and embarrassingly), I came to realize they were right. Bonds may be boring to an equity guy, and confusing to many investors, but what drives them – interest rates – reaches deep into the economy, affecting how companies and governments fund their operations and consumers make decisions. Rates are the single biggest factor affecting all asset classes.

Right now, fixed income is not only important, it's extremely interesting. Patterns that have endured for decades are being tested.

Cream puffs no more

Since the George Bush/Alan Greenspan era in the 1990s, U.S. Federal Reserve chairs, and therefore other central bankers, have been pushovers. At the slightest hint of economic slowdown, they've jumped to lower interest rates. They were trying to prevent any kind of deceleration, not just recessions. The bank rate became a tool for managing economic activity.

Three decades of accommodation and micromanaging, however, reached a breaking point in 2021 when we had near-zero, recession-like rates and an economy that was doing just fine. Something had to give and in 2022, short-term interest rates moved up significantly.

Today, U.S. Federal Reserve Chairman Jerome Powell, and others including Bank of Canada Governor Tiff Macklem, are under intense pressure to lower rates and stimulate the economy. So far, they've resisted, preferring to keep their powder dry in case there's a full-fledged recession.

Complicating the situation is the potential for tariff-induced inflation, for which higher rates, not lower, are more appropriate. The outlook for inflation is an important determinant of interest rates. Investors require a positive real yield – that is, a yield in excess of inflation – in return for tying up their money and taking risk. There are periods when this isn't the case, such as the go-go years of 2020-22, but they aren't sustainable. Either rates need to go up or inflation down.

Fed watchers who are hoping for lower borrowing costs should be careful what they wish for. For central bankers to get on board, a recession is likely necessary.

The mighty U.S. dollar

The U.S. dollar is the world's most important reserve currency. Countries fill their international currency reserves with it and investors rush to own it when times are difficult. But the chaos caused by the Trump administration has those same people questioning whether U.S. Treasury bonds are still the ultimate risk-free asset. Disrupting global trade, destroying long-standing alliances and running a US$2-trillion deficit has banks and global investors looking to other reserve currencies like the euro and yen.

I'm not suggesting the greenback will completely fall off its pedestal, but the scrutiny and lack of trust is unprecedented and is worth watching.

Where are the canaries?

Throughout my career, the high-yield bond market has been an early indicator of trouble in the stock market. Tighter credit, rising defaults and higher yields were canaries in the coal mine.

This time around, the opposite occurred. While tariff turmoil had stocks gyrating down, credit markets didn't even flinch, at least initially.

Some perspective is useful here. We've been experiencing one of the great credit cycles of all time. Since the 2008-09 financial crisis, there were a few hiccups, the COVID period being one, but each was short-lived and inconsequential. Steady demand for high-yielding investments and minimal defaults meant risk-takers were rewarded.

Despite this long run of success, lenders are now starting to take their cue from the stock market. Buyers are worrying more about economic disruption and a rise in defaults. Credit spreads have widened (explained below) and Goldman Sachs recently raised its default forecast to 5 per cent for high-yield bonds (from 3 per cent) and 8 per cent for leveraged loans (from 3.5 per cent).

As a reminder, investors demand higher yields for bonds that carry an increased chance of default. The yield in excess of a government bond (with similar terms) is called a spread. Spreads vary widely and are cyclical. A bond issued by a Canadian bank might have a spread of 1 per cent to 2 per cent while a junior mining company might be 10 per cent to 15 per cent.

Diversification

There's one relationship not on my list that's getting plenty of buzz. Many are questioning whether bonds are still a diversifier, given that they've recently been moving in sync with stocks. This occurs from time to time. Bonds may not be smoothing the daily path of balanced portfolios right now but if we end up in recession, rates will come down (inflation be damned) and bond prices will rise.