Evening Brief – 09.25.23

Corporate Vs. Government Bonds

It may be counterintuitive to question corporate bond spreads over government bonds with yields at a decade high. However, high yield spreads have fallen from 5.9% in July 2022 to 3.9% today, and investment grade spreads have fallen from 1.7% to 1.2%.

Spreads look to be reasonable by recent standards. High yield spreads were significantly higher from September 2014 to November 2016 (as measured by the ICE BofA US High Yield Index Option-Adjusted Spread), then lower from 2017 to 2019, peaking during the pandemic, and then falling to new lows beginning in 2021.

But market participants contend that this is not a “normal” landscape. The global economic outlook has brightened, but an inverted yield curve remains a warning sign of impending recession.

Some economic deterioration looks to be inevitable, and investors may expect increased compensation for rising defaults. There have been various indications of corporate distress. Bloomberg recently mentioned a $500 billion “corporate debt storm” brewing over the global economy, predicting a wave of corporate bankruptcies.

But the picture looks to be more subtle. Absolute yields are high due to elevated government bond yields, and corporate credit now provides competitive returns in comparison to other asset classes. The overall yield on BB-rated bonds is at a 10-year high. For the first time in years, credit is fighting for the spotlight with equity.

Similarly, default rates are low across much of the corporate bond market. Defaults on investment grade bonds are extremely low. Defaults, when they happened, were mostly limited to the bottom end of high yield or distressed loans.

Spreads were far greater during the Lehman crisis or at the height of the pandemic, reaching 4% for investment grade and more than 10% for high yield. Few would dispute, however, that the environment is that bad today.

Recession is still possible, but it is more likely to be brief and shallow, which should support corporate earnings. The risk is inflation, which affects the entire bond complex rather than simply corporate bonds.

With improving news on global inflation and central banks appearing to be nearing the conclusion of their rate hike campaign, this appears to be a decreasing possibility.