Corporate Bond Spreads Are Flashing Red

Every once in a while, the term “bond spread” pops up in financial reporting. Most people (who aren’t money nerds) don’t know what this means and how big a deal it sometimes is. So — since it’s a major red flag at the moment — this might be a good time to discuss it:

Bond spreads refer to how different kinds of bonds in a given category can have different yields. The gap between one kind of bond and another is the “spread.”

Sometimes, the gap between relatively safe bonds and more risky bonds conveys important information. When this spread is wide, it means bond buyers are nervous about the future and are demanding higher interest rates to induce them to buy risky bonds.

When the opposite is true — narrow spreads between safe and less safe bonds — that tells us that bond buyers are confident about the future and are willing to buy risky bonds even if they yield only a little more than safe ones.

At the extremes, bond buyers, like the rest of us, tend to be guided by emotion and are therefore frequently wrong. So small spreads mean bond buyers are possibly overconfident, while wide spreads denote the opposite.

Where is today’s corporate bond market? At scary levels of complacency:

Corporate bond spreads hit a record low last week — and may be an early sign of a bubble

(MarketWatch) - Investment-grade and high-yield corporate bond spreads in the U.S. fell to all-time lows last week in a development that could be viewed as an early sign of a bubble, S&P Global Ratings said Monday.

Investment-grade spreads — the extra compensation investors demand for the additional risk of taking on corporate debt — tightened to 82 basis points over Treasurys on Nov. 12, while high-yield spreads tightened to 214 basis points on Nov. 14, the agency said in a report.

That matters because interest rates have been elevated on a historical basis for more than two years in response to the Federal Reserve’s monetary-tightening cycle.

“Spread levels may be masking the strain on actual borrowing costs and debt sustainability some corporates are facing,” said the S&P report. “This aggressive pricing may also be interpreted as the first signs of a ’bubble’.”

Editorial note: The MarketWatch article included a chart that is incomprehensible. So I replaced it with something easier to understand:

The spread move has come despite expectations for fewer rate cuts in the coming months than previously expected and growing uncertainty ahead, according to the report.

The move is also limited to the U.S., at least for now. Spreads overall are falling globally, but European spreads remain above all-time lows as the Russia-Ukraine conflict has widened spreads in the region.

Still, there are other supportive factors for credit markets, and the spread move may not be a sign of market complacency.

U.S. growth remains robust, with real GDP expanding at a 2.8% clip over the prior four quarters. The Atlanta Fed is expecting 2.5% growth in the fourth quarter.

U.S. corporate earnings also remain positive, with growth seen through 2024 and profits positive since 2021.

“While corporate yields have remained elevated, the relative widening of government benchmark yields has been greater,” said S&P.

Yields on BBB-rated corporates have risen 32 basis points, while yields on B-rated corporates have fallen 14 basis points. At the same time, 10-year Treasury yields have climbed 58 basis points.

Yet Another Thing About to Go Wrong?

When bond spreads are tight—like now—the implication is that risky companies are finding it relatively easy to borrow. Frequently, that’s followed by some kind of “credit event,” like a major corporate bankruptcy or economic downturn that raises borrowing costs for weaker companies. Many of those “junk” borrowers then go bankrupt, adding momentum to the broader economic downturn.

This was true in the late 1980s when the junk bond bubble burst, and was emphatically true in the 2000s when the subprime mortgage bubble burst. Today’s record-low bond spreads imply that complacency is as high as it was in those previous cycles.

So… what would cause bond buyers to panic and bond spreads to widen again? The simplest bet would be for government bond yields to keep rising until they break the real estate and stock markets. See Do We Face a "Minsky Moment"? and These Two Things Don't Go Together.