The outperformance of US small cap stocks in the third quarter served as a good reminder that the small cap premium—though it has fallen out of favor from time to time over the past 100 years or so—has persevered over the long term.

Down more than 20% for the year to date through early April, the Russell 2000 Index has since rallied around 40%, including a 12.4% gain in the third quarter, outpacing the S&P 500 Index in both instances. This dynamic is worth noting given the chronic underperformance of smaller stocks since the financial crisis.¹ But does it represent a durable shift in relative performance toward the historical norm in which small cap stock have offered investors the potential for enhanced returns in exchange for higher perceived risk?

The rally’s persistence will likely depend on improved corporate fundamentals. Fortunately, we have begun to see just that. Amid a backdrop of 3.8% GDP growth and manageable inflation, Russell 2000 second quarter earnings growth came in at nearly 72% year over year, and estimates call for another 40%-plus expansion in the third quarter when reports start trickling out in the coming weeks. S&P 500 earnings growth, in contrast, was a relatively pedestrian 13.8% in the second quarter and is expected to slow into single digits in the third.² Earnings for small cap companies—who are far more reliant on floating-rate debt than their large cap counterparts—could get an additional boost from easing interest rates.

Given the size of the small cap market, recoveries can be sharp; it doesn’t take a massive amount of renewed buying interest to significantly move a market whose aggregate capitalization is less than that of several individual US stocks. Of course, there are a host of risks too numerous to mention in this forum that could disrupt this comeback.

As of late September, credit markets continue to offer historically elevated yields, even as spreads tighten across much of the landscape. This reflects strong investor demand for income alongside a willingness to accept lower compensation for taking on risk, which seems to be a theme over the last few quarters

Municipals stood out again this month with a favorable dynamic between yield and relative value. Investment grade munis (IG muni) offered a tax-equivalent yield-to-worst (YTW) of about 6%—slightly lower than the previous month. IG munis still place above their historical range. Spreads tightened again this month from 159 basis points (bps) in August to 138 bps in September, suggesting resilient demand even while yields edge down. As for high yield munis (HY muni), a similar case is found with tax equivalent YTW held at roughly 9% and spreads tightening slightly. Short duration high yield munis (SDHY muni) saw yields remain relatively unchanged, and spreads tighten by 28 bps.¹

The more cyclical parts of the credit markets showed mixed changes. Triple C rated high-yield corporate bonds held yields at roughly 10%, though spreads widened modestly to from 579 bps to 616 bps. In a similar fashion, leveraged loans offered yields around 8%, with spreads widening slightly. Meanwhile, securitized assets, such as asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), showed limited change, with spreads hovering near long-term averages.²

Overall, the persistence of elevated yields alongside tightening spreads highlights a market in which holding bonds for income remains compelling, but selectivity is key as the extra cushion investors get from spreads has shrunk. Municipals in particular appear favorable, offering not just competitive after-tax income but also potential diversification benefits tied to essential service issuers.