Investment-grade bonds, high yield and downgrades: how to read risk and prepare the portfolio

Credit risk is rising slowly today, while the market appears calm. And it is precisely in these phases that it makes sense to ask whether the portfolio is built to withstand even adverse scenarios.

by Vincenzo Lana, investor and economic-financial commentator

In recent months, the US corporate bond market has seemed, at least on the surface, surprisingly calm. Spreads compressed, solid demand, record issuance absorbed without particular stress. For many investors, especially those who see bonds as the “defensive” part of the portfolio, this backdrop feels reassuring. But looking under the hood, the signals that emerge tell a more complex story, especially if the time horizon shifts toward 2026.

The data released by JPMorgan, for example, are particularly interesting because they do not point to an imminent crisis, but rather to a gradual deterioration in credit quality. Around $63 billion of US corporate bonds currently classified as investment grade show characteristics typical of high-yield debt: BBB- ratings from some agencies, negative outlooks and valuations already deemed speculative by other observers. A year ago, the figure was $37 billion. The jump is significant. The key issue is debt refinancing in a context of rates that are structurally higher than in the past. Many companies continue to access the market without problems, but they are doing so at the cost of higher interest payments. This increases pressure on balance sheets, especially for the more indebted issuers. It is not a liquidity problem, at least for now, but one of medium-term sustainability.

On this last point, one figure worth noting is that of “fallen angels” (fallen angels): in 2025, around $55 billion of bonds moved from investment grade to high yield, compared with just $10 billion of “rising stars”. This imbalance signals that, overall, credit quality is deteriorating. And this is where the real risk mechanism comes into play, especially for those investing through ETFs.

Investment-grade bond ETFs replicate indices that, by definition, exclude securities that lose the required minimum rating. When a bond is downgraded to “junk”, the ETF is forced to sell it, often at the worst possible moment, when spreads explode and liquidity dries up. There is no discretionary judgment: it is a mechanical sale. The high yield ETF, by contrast, tends to include that security only after the downgrade, when the price has already undergone a sharp adjustment. This mechanism is crucial to understanding why investment-grade ETFs are not risk-free, especially when spreads are very compressed, as they are today: with spreads around 70–80 basis points, well below the historical average, the margin of safety is thin, and it takes only a moderate increase in downgrades or a worsening of the economic cycle to produce disappointing performance.

In the high yield segment, the situation is even more delicate. The yields on offer are higher, but so are the risks. If the flow of “fallen angels” continues to exceed that of companies improving their credit standing, the high yield universe could end up populated by former investment grade issuers with balance sheets under pressure. In a scenario of economic slowdown in 2026, this would increase the probability of default and widen spreads. High yield ETFs could therefore offer attractive nominal returns, but with volatility often underestimated by retail investors.

Aggregate ETFs, which combine government bonds and corporates, represent a middle ground. However, many European investors tend to view them automatically as “defensive”, without analysing the composition. In reality, a significant part of performance depends on the investment-grade corporate component. If this enters a period of stress, the stabilising effect will depend heavily on the share of government securities and on overall duration. A different matter is government bond ETFs: in a scenario of economic slowdown in 2026, government bonds could once again play their classic role as portfolio stabilisers, especially if central banks were to adopt a more accommodative tone. They may not deliver exceptional returns, but they can offer protection when credit is under pressure.

This is where the difference between passive and active management also comes into play. An active bond fund, unlike an ETF, is not forced to sell a security automatically upon a downgrade. It can anticipate the risk by reducing exposure earlier, or decide to keep the security if it believes the market is reacting excessively. It can also actively manage duration, liquidity and sector exposure. But that does not mean an active fund is automatically better, because a manager must pay close attention to several factors: issuer leverage levels, the sustainability of investments linked to artificial intelligence, the risk of debt-financed acquisitions and companies' ability to maintain sufficient margins in an environment of higher financing costs. If these assessments are wrong, the active fund can perform worse than an ETF, especially in periods of stress.

For the European retail investor, the issue is different again. Many invest in bond ETFs to diversify their equity portfolio, but often without considering credit risk or currency risk. An unhedged US corporate ETF also exposes the investor to the dollar, which can significantly amplify or reduce returns. Moreover, concentrating the entire bond allocation in US investment-grade corporates amounts to an implicit bet on the resilience of US credit. Looking ahead to 2026, a more prudent approach might be to diversify not only by asset class, but also by type of risk: combining government bonds, aggregate funds, a moderate allocation to investment grade corporates and, only if consistent with one's profile, a small exposure to high yield. Not forgetting that bonds are no longer the automatic “safe haven” many came to know during the zero-rate decade.

The message coming from the data is not alarmist, but it does call for awareness. Credit risk today is not obvious; it does not make a sound. It grows slowly, while the market appears calm. And it is precisely in these phases that it makes sense to revisit one's exposures, understand what one really owns and ask whether the portfolio is built to withstand even less favourable scenarios.