The US economy is at risk of tipping into a recession in the second half of the year, derailing the corporate debt rally, according to Chris Alwine, global head of credit at Vanguard.

“We can see credit perform OK — not extraordinary outperformance — in the first half of the year,” Alwine said in an interview with Bloomberg Intelligence’s Credit Edge podcast. “If we look beyond that, our concerns begin to grow.”

Alwine, whose firm manages $8.6 trillion in assets, bases his recession call on the idea that further weakening in the labor market will boost unemployment. He also sees a risk of the Federal Reserve not moving fast enough to cut rates. 

“What would precipitate that shallow recession is that corporations are just not hiring, with a modest increase in layoffs, coming from the idea that margins weaken a bit and earnings aren’t growing as fast as companies would like,” said Alwine.

A slight economic downturn could push the US investment-grade corporate bond spread as high as 150 basis points over Treasuries, from 94 basis points currently, according to Vanguard. The spread measures the extra compensation, or yield, that investors get over government bonds to compensate for the risk of non-payment.

Alwine doesn’t expect a lot of credit downgrades or defaults given “relatively healthy” corporate fundamentals. He predicts the Fed will start cutting rates in May or June, spurring an exodus of cash from money-market funds and into credit with short-to-intermediate duration.

“However, we believe that the later they do their first cut, the risk of recession begins to increase,” said Alwine, referring to the Fed lowering interest rates. 

In corporate debt, Alwine is mostly worried about investment-grade companies piling on debt through mergers and acquisitions, as well as junk-rated borrowers that are dependent on leveraged loans.

“Where we would see vulnerabilities are in A rated industrial credits that have the capacity to lever up, possibly through acquisitions,” said Alwine. “Valuations are quite poor, with the risk of a leveraging transaction that would result in a downgrade in a weakening economic environment.”

He particularly likes bonds from banks, which tend to issue shorter-term debt, particularly money-center financial institutions.

“I like front-end financials at this stage” said Alwine, referring to one-to-five-year maturities. “It’s actually one area where valuations are not stretched.”

Within investment-grade debt, Vanguard is bullish on BBB rated consumer non-cyclical sectors like pharmaceuticals and telecommunications.

In high yield, Alwine expects default rates to rise, but to about 3%-5% — not the double-digit levels typically seen in a recession, which would hit the lowest-rated bonds hardest. He’s more defensive on leveraged loans, where Vanguard sees worse fundamental credit quality than in the past.

He sees downgrades and possibly defaults coming down the pike for loan-only issuers who have been more stressed from interest rates climbing.

“We are very defensive within high yield today,” said Alwine. “Although we still like credit in this window of soft-landing theme, Fed supporting risk taking, we prefer to do that in higher quality, meaning investment grade.”

Vanguard also has a “modest overweight” in European credit relative to the US, though the former has more near-term recession risk. Alwine avoids Chinese corporates because of lack of transparency and disclosure, but he likes rates in emerging markets.

This article was provided by Bloomberg News.