Rising US Fiscal Deficits and Credit Downgrades: A New Era for Fixed Income Allocation?

The United States is at a crossroads in its fiscal trajectory. After a brief respite in June 2025—when a $71 billion deficit marked a 57% drop from the previous year—the broader picture remains grim. The Congressional Budget Office's projection of a $3.4 trillion debt increase over the next decade from the recently enacted H.R.1 tax and spending package, coupled with Moody's downgrade of the US from Aaa to Aa1, signals a systemic loss of confidence in America's fiscal stewardship. For fixed-income investors, this raises a critical question: How should portfolios adapt as Treasuries lose their once-untouchable allure?

The Treasury Conundrum

The 10-year Treasury yield, long a cornerstone of global risk-free rates, now trades at 4.35%, but its appeal is eroding. The downgrade forced investors to recalibrate their assumptions about sovereign risk, with the risk-free rate now effectively 4.01% after subtracting a 40-basis-point default spread for the Aa1 rating. This adjustment has subtle but meaningful implications: corporate bonds, which previously offered yields just slightly above Treasuries, now appear relatively more attractive. The Bloomberg US Corporate Bond Index, for instance, yielded 5.2% in June 2025, with an option-adjusted spread of just 85 basis points. While the spread is narrow, the absolute yield is compelling in a world where inflation and borrowing costs remain stubbornly high.

The Federal Reserve's Z1 report underscores the urgency. Corporate liquid assets have fallen to 90% of short-term liabilities, and while investment-grade issuers remain well-positioned to weather a slowdown, the margin for error is shrinking. Yet, these bonds offer a critical advantage: diversification away from a sovereign asset (Treasuries) that is increasingly perceived as a liability.

High-Yield Corporate Bonds: A Misunderstood Opportunity

Investment-grade corporate bonds have outperformed the broader bond market in 2025. The iShares 5-10 Year Investment Grade Corporate Bond ETF (IGIB) and the Vanguard Intermediate-Term Corporate Bond Index Fund (VCIT) have returned 5.48% and 3.96%, respectively, over the past year. These figures eclipse the 4.30% return of the Morningstar US Core Bond Index, which includes lower-yielding Treasuries.

The case for corporate bonds is bolstered by their structural advantages. Floating-rate notes (floaters), for example, have outperformed fixed-rate counterparts since the Fed began cutting rates in September 2024. The Bloomberg US Floating Rate Notes Index now offers yields comparable to intermediate-term corporate bonds but with lower volatility. For income-focused investors, this is a compelling trade-off.

The Alternative Credit Renaissance

Alternative credit markets, long dismissed as niche, are emerging as a critical component of a rebalanced portfolio. Private credit, in particular, has gained traction as traditional banks retreat from riskier lending. JPMorgan's $50 billion commitment to private credit underscores its strategic value, though Jamie Dimon's caution about opaque ratings and leverage is warranted.

The data tells a nuanced story. Private credit defaults in 2025 stand at 2.4%, far below the 5.8% rate in high-yield bonds. Yet, private credit offers a 10% starting yield, providing a buffer against even moderate defaults. For investors willing to accept higher illiquidity, this asset class offers a dual benefit: higher returns and a hedge against Treasury underperformance.

European markets, too, are showing resilience. EUR investment-grade and high-yield bonds have attracted inflows despite a 3.1% and 5.3% yield spread to Treasuries. The Eurozone's corporate balance sheets, though weaker than their US counterparts, remain robust enough to justify inclusion in a diversified portfolio.

Rebalancing the Portfolio

The shift in fixed-income allocation should be deliberate and measured. Here's a framework for action:
1. Reduce Treasury Exposure: Treasuries now offer a yield that is increasingly disconnected from their perceived safety. Reallocating even 10–15% of Treasury holdings to high-quality corporate bonds can enhance yield without sacrificing credit quality.
2. Prioritize Floaters and Preferred Securities: Floating-rate notes and preferred securities, particularly those with tax-advantaged structures, offer a dual edge: protection against rate cuts and a yield premium over Treasuries.
3. Diversify into Alternative Credit: Allocate 5–10% of the fixed-income portfolio to private credit and structured finance. Focus on managers with strong underwriting discipline and a track record of navigating economic cycles.
4. Monitor Fiscal Catalysts: The CBO's 2055 debt-to-GDP projection of 156% (or 220% under extended tax cuts) is a long-term risk. Short-term, however, the focus should remain on near-term fiscal policy and its impact on corporate earnings.

The Road Ahead

The US fiscal landscape is evolving, but the tools to adapt are within reach. High-quality corporate bonds and alternative credit markets offer a path to preserve income and diversify risk in an era of eroding Treasury yields. As Moody's downgrade reminds us, complacency is no longer an option. Investors must act with clarity and foresight, rebalancing portfolios not just for yield, but for resilience.

For those who hesitate, the cost of inaction may be steep. The new era of fixed income is here—and it demands a new playbook.