The "AI bubble" hasn't burst yet, but this bond veteran has quietly reduced credit bond holdings to the lowest level since 2012: "Don't be too greedy, it's time to pull back."

According to Zhitong Finance APP, Scott Colbert, during his four-decade career in bond investing, rarely felt it necessary to make major adjustments to his strategy. But he says now is one of those critical moments. Colbert serves as Director of Fixed Income at Commerce Bank in Clayton, Missouri, managing $28 billion in assets. He doesn't foresee economic clouds looming—in fact, he expects economic growth to accelerate in the coming months. The problem, however, is that corporate debt is currently priced too high with little margin for error, making the potential returns insufficient to compensate for the risks taken.

From AT&T (T.US) and JPMorgan Chase (JPM.US) to Amazon (AMZN.US), the yield on bonds issued by blue-chip U.S. companies is only 0.8 percentage points higher than that of U.S. Treasuries—a premium close to the lowest level in nearly thirty years recorded earlier this year. This means that a spread widening by just about 12 basis points would be enough to wipe out the annual excess return of these bonds over Treasuries.

This is part of the reason why Colbert has reduced his exposure to corporate credit bonds to the lowest level since 2012. Meanwhile, he has increased allocations to the safest assets in the fixed-income market—U.S. Treasuries, agency bonds, and cash—to the highest proportions since 2005.

At 65, Colbert has managed the $1.1 billion Commerce Bond Fund since 1994, making him the longest-tenured manager among Morningstar-rated peers. He said, “Opportunities in the market are really limited. The reward for the risks I’m taking is the lowest I’ve ever seen in my career.”

This adjustment has yet to yield significant returns. Year to date, the overall U.S. Treasury index is down about 0.1%, slightly underperforming corporate bonds and the broader fixed-income market, as concerns over inflation and deficits push long-term yields near twenty-year highs. To ease the pressure, U.S. Treasury Secretary Scott Besant unexpectedly announced on Wednesday an increase in long-term Treasury buybacks.

Nevertheless, Colbert remains patient—his fund has outperformed 94% of its peers over the past 15 years. He has been steadily reducing risk for quite some time. The latest data shows that, as of the end of June, the proportion of corporate bonds in his mutual fund and separate accounts has dropped to 39%, well below about 53% in 2021.

Meanwhile, holdings of Treasuries and cash have risen from less than 16% five years ago to 23%. Some government-guaranteed mortgage-backed securities (MBS) more than doubled in proportion during this time, reaching 27%.

This tilt towards higher-quality assets has increased the average credit rating of his portfolio from A+ to AA-, the highest level on record.

This repositioning comes as investors are attracted by absolute yields rarely seen since the financial crisis, and resilience in the economy is driving massive inflows into credit markets. These inflows have further compressed the premium of corporate bonds over Treasuries, bringing them close to the narrowest levels since 1997, even as technology companies dramatically increase issuance to fund investments in artificial intelligence (AI), boosting supply.

Colbert noted, “If there’s ever a time to modestly reduce risk, it’s now—because the yield you give up is at its least.”

Historically, Colbert’s credit risk exposure has always been higher than the benchmark—the Bloomberg U.S. Aggregate Bond Index. Even after cutting back, his current corporate bond exposure is still about 15 percentage points higher than the Treasury-heavy benchmark.

Therefore, this reduction is not a bet on economic downturn, but a risk management strategy.

Colbert admits, “If the market really collapses, I’ll get hurt too. So I’m not expecting that to happen. It’s just that, at the margin, I’m not willing to take as much risk as I used to.”

Worries About an “AI Bubble”

One of the risks Colbert is monitoring closely is the stock market.

The AI boom has pushed the total market capitalization of the U.S. stock market to about $82 trillion, more than 250% of the U.S. economy—about 100 percentage points higher than the peak of the internet bubble.

Colbert doesn’t think the AI hype—what he calls a “bubble”—will burst any time soon. But he worries that if the stock market becomes volatile, it could impact consumer spending, which is currently backed by household wealth growth.

Originally trained as a nuclear engineer, Colbert entered the investment industry in 1986, when he was hired by Armco Steel, then one of America’s largest steelmakers, to manage the company pension fund’s bond investments.

He recalled, “When I first started, they told me, ‘We’ll let the smart people in Chicago, New York and London handle the stocks. But the bonds—well, any outsider can manage those.’ I was that ‘outsider’.”

But he entered the field at just the right moment. At the time, Paul Volcker was working to rein in inflation, launching a multidecade bull market in bonds. In 1993, Colbert joined Commerce Bank and took over the Commerce Bond Fund a year later.

Unlike some investors who bet on the trend of interest rates, he keeps the duration (a measure of interest rate risk) of his portfolio close to the benchmark. Instead, he seeks excess returns through spread products such as corporate bonds, mortgage-backed securities, and asset-backed securities.

This strategy has delivered consistently strong results. Over the past 15 years, the fund has had an average annual return of 2.5%, well above the benchmark.

Colbert notes that today’s market environment reminds him of the late 1990s internet bubble. Then-Fed Chair Alan Greenspan warned of “irrational exuberance” in 1996, causing a brief market pullback, but the rally lasted for years afterwards.

Colbert concludes that the lesson is that high valuations can persist much longer than investors expect, making it virtually impossible to time the market precisely. Rather than trying to call the turning point, it’s better to calmly reduce risk when the cost of doing so is low.

He said, “When things are going really well, I’d rather pull back just a little. Don’t get too greedy.”