Credit Market's Narrow Spreads Signal Risk Ignored

Key Takeaway

• Corporate debt spreads are at their lowest in 2.5 years, signaling complacency and underestimation of rising credit risk.
• Historical parallels suggest potential for significant widening of spreads amid geopolitical tensions, policy errors, or a US recession.
• Despite strong recent performance, the credit market's disregard for fundamentals could lead to sharp corrections.

Credit Market Complacency

The current state of the credit market is marked by exceptionally narrow spreads across various segments, including investment-grade and junk bonds, as well as collateralized loan obligations. The spread on the Bloomberg US Corporate Index has notably fallen to 86 basis points (bps), the lowest since late 2021, signaling a significant compression from the five-year average of about 120 bps. This contraction reflects a robust demand for corporate bonds amidst a limited net new supply and a general market perception of a stable macroeconomic outlook, further buoyed by memories of the Federal Reserve's corporate bond bailout during the Covid crisis.

Warning Signs Ignored

Despite the seemingly favorable conditions, there are clear warning signs that the market is overlooking. The current spreads do not adequately compensate for the rising corporate credit risk, suggesting a level of market complacency reminiscent of the period just before the global financial crisis. Historical instances, such as the 2011 European sovereign debt crisis and the 2020 economic shutdown due to the coronavirus, demonstrate how quickly investment-grade risk premia can spike in response to market volatility. The potential for increased volatility is underscored by geopolitical tensions, policy errors by the Federal Reserve, and the looming threat of a US recession, all of which could lead to a significant widening of spreads and impact credit portfolios adversely.

The Valuation Conundrum

Analysts from Goldman Sachs have highlighted a "valuation conundrum," questioning how spreads can remain so low amidst restrictive monetary policy and relatively high inflation. This conundrum is further complicated by the underperformance of borrowers within the Bloomberg US Corporate Index relative to the S&P 500, with earnings missing estimates by about 7% on average. Despite this, the deterioration in credit quality has been relatively slight, starting from a strong level, which may explain the continued investor interest in corporate bonds. However, history suggests that when spreads reach such low levels relative to their recent averages, they tend to continue narrowing until a triggering event causes them to widen.