Credit spreads are very tight

Some measures of corporate credit spreads have reached their tightest levels in the past 23 years. Does this mean that optimism has peaked and it's time to sell? Not necessarily.

The chart above compares the yield on 5-yr A1-rated Industrial bonds with the yield on 5-yr Treasuries. The spread, or the difference between the two, is now 35 bps, which is very close to its lowest level (31 bps) in Bloomberg's recorded history, which was reached in March, 1997—four years before the next recession would strike. Like then, investors are willing to accept a very small premium in extra yield relative to a Treasury, in exchange for assuming the credit risk of the average A-rated Industrial issuer. This also implies a high level of confidence in the ability of those companies to make good on their obligations.

Confidence in bond-land is pretty high, but that doesn't mean a recession is just around the corner. It means that the economic and financial fundamentals for corporate cash flow are very positive and default risk is very low. That will change when another recession sets in, but something—other than tight credit spreads—will have to trigger it.

The chart above compares the spread to Treasuries of 5-yr A1 Industrial bonds and the spread
to Treasuries of 5-yr swap contracts, which can be thought of as representing the credit risk of AA-rated banks. Here you can appreciate how significant the recent decline in spreads has been.

Both swap spreads and credit spreads tend to rise in advance of recessions and decline in advance of recoveries. For now, they are very low and could decline a bit more. But when spreads are this tight, it doesn't pay to put a lot of your eggs in the corporate bond basket, especially of the investment grade variety. If the economy picks up, yields are very likely to rise and default risk is likely to decline further, but it can't go a whole lot lower than it already has. The current level of credit spreads and yields doesn't offer much (if any) cushion against the negative impact of rising yields. In other words, rising interest rate risk is now of much more concern to high-grade corporate bond investors than is default risk.

Posted by Unknown

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