A closely watched credit-market gauge shows that investors still have appetite for risk, despite fears of a recession and the possibility that the Federal Reserve may raise its benchmark interest rate again by year-end, and keep rates higher for longer than anticipated.
Credit spreads, which refer to the compensation investors can earn on corporate bonds versus the risk-free U.S. Treasury rate, remain tight compared with historical levels. The gauge tends to widen in jittery markets or when economic growth looks likely to slow, which can make investors more wary about not getting paid back in full due if corporate defaults climb.
The ICE BofA High Yield Index Option-Adjusted Spread, a measure of the premium investors are paid to invest in high-yield corporate bonds versus Treasurys, stood at 389 basis points above the risk-free rate as of Thursday. The index’s spread jumped to over 2,000 basis points over the benchmark in 2008 during the financial crisis. It rose almost 1,100 basis points above Treasurys in 2020 when the COVID crisis broke out in the U.S.
High-yield bonds, also known as “junk bonds,” have been around in force since the 1980s as a popular way for Wall Street to fund leveraged buyouts or for companies with weak finances to borrow. Junk bonds also can serve as a canary in the coal mine, sniffing out downturns early, because they tend to succumb to selling pressure quickly, like stocks, when the economic outlook gets cloudier or credit markets wobble.
The two biggest U.S. junk-bond exchange-traded funds rose Friday. The iShares iBoxx $ High Yield Corporate Bond ETF
HYG
and SPDR Bloomberg High Yield Bond ETF
JNK
both gained about 0.2% Friday, according to FactSet, two days after the Fed indicated it could keep its policy rate above 5% for longer than anticipated.
The S&P 500 index
SPX
rose 0.2% on Friday, and the Nasdaq Composite Index
COMP
advanced 0.4%, while the Dow Jones Industrial Average
DJIA
was mostly flat.
Junk bonds pay investors more than investment grade bonds, because they have lower ratings and higher risks.
“High-yield debt spreads are still not showing any degree of concern for either default or economic risk right now, and that supports the case for continued strength in risk assets in the near-to-medium term, despite lingering recession concerns based on the inverted yield curve,” Tyler Richey, co-editor at Sevens Report Research, wrote in a recent note.
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Tight credit spreads partly result from investors’ optimism around a soft landing, where inflation would cool down, while the economy avoids a recession, according to William Merz, head of capital market research at US Bank. Consensus estimates for GDP and corporate earnings continued to trend higher, with the Atlanta Fed predicting the U.S. economy to grow at a 4.9% annualized rate in the third quarter, according to the Atlanta Federal Reserve’s GDPNow forecast.
Investors also have seen intensive fiscal stimulus this year. “We are in an environment, so far this year, that we’re seeing fiscal stimulus as though we are in the middle of a major crisis, but we’re not. That’s offsetting monetary policy tightening to a meaningful degree,” Merz said.
Credit spreads nearing cycle lows could also, in part, be attributed to the supply and demand dynamic of corporate bonds, according to Thomas Urano, co-chief investment officer at Sage Advisory.
Investment grade bonds, on the other hand, are providing yields of about 5.9%, which may attract some buyers that are not as sensitive to spreads. A big part of that yield, however, can be attributed to the 10-year Treasury rate’s
BX:TMUBMUSD10Y
sharp climb to 4.479% as of Thursday, the highest since October 2007. The yield on the 10-year Treasury was 4.48% on Friday, down 1 basis point.
From the demand side, foreign investors also seem to been more active in the corporate space, noted Urano.
Increasing demand and reduced supply this year, as Fed rate hikes push up corporate borrowing costs, sets up a backdrop for credit spreads to tighten, Urano said, in a call.
If the current dynamic continues to hold, without the U.S. economy suddenly falling off a cliff, “I think you can easily see the corporate sector grind tighter in spread,” according to Urano. However, as the economy continues to slow in 2024, investors may revert to pricing in recessions, and it could put pressure on credit spreads, noted Urano.
Merz said his team continues to support a “normal” exposure to high-yield bonds, which often ranges from 3% to 5% of a portfolio.
“We are not at the point, yet, to say that high yield is expensive. Until we see credit spreads start to move wider, signaling the potential downside risks, we are comfortable clipping that compelling current income,” said Merz.
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