Understanding credit spreads and their implications is crucial for any investor looking to navigate the complex world of bond markets. The time to worry about credit spreads is when they become too narrow, as is the case now.
Despite rising consumer defaults, resuming student loan payments and escalating corporate bankruptcies, investors appear to be demanding less yield for junk bonds, even as debt issuers face to increased credit tensions. A credit event would bring these investors back to reality.
What are credit spreads and what do they mean?
Let’s understand what credit spreads are. A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. Investors monitor these spreads to assess the risk associated with a particular bond. When the spread narrows, it indicates that the market perceives less risk. Conversely, a widening spread suggests higher perceived risk.
Historically, there is a strong link between widening credit spreads and stock market volatility. The implication here is simple.
Just as volatility reverts to the mean when it becomes too low for an extended period of time, so do internal credit spreads in the bond market.
Currently, credit spreads are remarkably tight, reflecting a market perception of low risk. This is frankly bizarre given the current economic uncertainties and the high-risk nature of junk bonds.
For example, the risk of increased consumer defaults and the resurgence of student loan repayments should logically lead to a widening of credit spreads. Additionally, an increase in corporate bankruptcies generally increases the risk associated with junk bonds, guaranteeing more substantial returns. However, the market appears to be showing strangely reduced concern about current credit conditions, as evidenced by the demand for lower yields on junk bonds. This is precisely what should concern everyone.
One possible explanation for this is the strength of corporate balance sheets. Despite economic uncertainties, many companies have managed to maintain healthy balance sheets. This financial stability could contribute to a tightening of credit spreads, as investors perceive lower default risks.
The bottom line on junk debt
However, this does not eliminate the potential risks associated with increased consumer defaults, student loan payments, and increased business bankruptcies. The yield curve, let’s not forget, continues to scream recession.
Tightening lending standards, despite healthy corporate balance sheets, portend a possible credit event, combined with overseas risks and zombie companies that may not be able to survive at higher rates when they renew their debts. If risk appetite reverses, credit spreads could widen rapidly, leading to substantial losses for junk bond investors. A credit event focused on speculative debt could lead to significant market dislocation, affecting not only the bond market but also the financial market as a whole.
Current narrow credit spreads, despite a high-risk environment, should serve as a wake-up call to investors that they could be surprised and wrong-footed by a sudden and rapid reassessment of default risk. Junk debt can only be reduced for a limited period of time compared to high quality paper in the bond market, and what worries me is that no one is prepared for it. Historically, the ratio of Treasuries to junk debt is at record highs. I suspect this will happen soon.
As of the date of publication, Michael Gayed did not hold (neither directly nor indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the author, subject to InvestorPlace.com Publishing Guidelines.