Corporate Debt Spreads Indicate Complacency in Credit Market

By James Crombie, Bloomberg Markets Live writer and strategist

Corporate Debt Spreads and Potential Triggers

The slim spreads on corporate debt may seem insignificant until they're not. There are several possible catalysts that could cause risk premiums to surge, negatively impacting credit portfolios. Spreads have plummeted across the board, from investment-grade and junk bonds to collateralized loan obligations. The additional yield investors receive for owning US high-grade corporate debt instead of government bonds is at its lowest in two and a half years.

Current State of the Market

At less than 90 basis points, this is significantly below the five-year average of about 120 basis points. As a percentage of the total yield, it's the lowest since 2007. These slim risk premiums reflect the booming demand for the limited net new supply of corporate bonds, coupled with a general lack of worry about the macroeconomic outlook. The perception of a central bank backstop underpinning the debt has been strengthened since the Federal Reserve bailed out corporate bonds during the Covid crisis.

Investor Complacency and Risks

Investors have been lulled into believing this is the new norm, but such a meager yield pickup does not adequately reflect the increasing corporate credit risk. Therefore, when volatility returns to shake investors from their complacency, expect credit risk premiums to surge, negatively impacting portfolios.

Historical Precedents and Future Risks

Credit usually follows broad measures of volatility, with spreads widening when markets become volatile. However, since December, when corporate bond buyers were bullish on the idea of six rate cuts in 2024 and a soft landing in the US, they've diverged. There are uncanny similarities with the period just before the global financial crisis, with high-grade spreads and bond yields at around the same levels. After that bubble burst, investment-grade risk premiums soared above 600 basis points.

Market Vulnerabilities and Potential Fallout

In addition, the credit market is vulnerable to a sustained exodus of funds fleeing negative returns. High-duration corporate bonds lose money when yields rise, prompting investors to seek better options with more generous yield spreads. There's also the threat of policy errors or even a rate hike from the Fed, and a US recession can't be ruled out. Both scenarios would wreak havoc on debt portfolios.

Current Market Conditions and Risks

Ironically, the only area where credit investors seem to have exercised some caution is in the riskiest debt, which is most likely to cause harm as rates remain high for longer. Risk premiums on bonds rated CCC have tightened 60 basis points this year, or 8%. That compares with a 13% contraction in high grade.

Impact on Borrowers and Market Outlook

Of course, a stable US economy is good news for borrowers and a strong demand for yield provides support. However, earnings are eroding, particularly in the financial sector, which makes up 30% of the market. Interest-coverage ratios are slowly increasing as high-for-longer rates take their toll, even on better-quality borrowers.

Future Predictions and Potential Risks

Spreads may continue to tighten as high yields increase demand for the limited net supply of new bonds. But this will only amplify the scale and speed of the inevitable flare-up when volatility increases and credit reverts to something more closely resembling long-term averages.

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