Why Tight Credit Spreads Shouldn’t Keep You on the Sidelines
Comparing current credit spreads to their historical average is one way to value corporate bonds — analogous to using price-to-book ratios for stocks. If spreads are above average, bonds are considered cheap or loose. If spreads are below their long-term average, bonds are considered rich or tight.
With investment-grade corporate bonds (IG corporates) rallying 5% over the past year, their credit spreads are now 35% below their long-term average.1 The same trend holds for below investment-grade high-yield bonds; their spreads are 39% below their historical average following a 13% rally in the past year.2
But tight credit spreads don’t always mean unattractive returns are on the horizon. And tight spreads certainly shouldn’t keep investors on the sidelines.
How Tight Are Today’s Credit Spreads?
Time periods matter when evaluating credit spreads. A 20-year average includes the massive spike in spreads during the Global Financial Crisis (GFC), while a 10-year average completely removes it. A three-year average sidesteps the liquidity-fueled spread shock that occurred during the onset of the COVID-19 pandemic.
But no matter what lookback period we use, investment-grade corporate bond credit spreads are tight (Figure 1). And over a longer 30-year lookback, they trade right at the bottom quintile.3
This trend is exaggerated with high yield. Current high yield credit spreads are below all periodic averages and sit in the bottom 11th percentile over the past 30 years (Figure 2).4
What Drove Credit Spread Tightening?
The risk-on rally was ignited by the dovish pivot from the Federal Reserve (Fed) in the fall of 2023 when the Fed altered its view on when it might start cutting rates. Spreads tightened by 25 basis points and 67 basis points for investment-grade and high yield, respectively, that November.5 IG corporates saw their largest one-month spread change since April 2020, and high yield fell below its moving 3-year average — where it’s remained ever since (Figure 3).6
Tight Spreads Can Still Produce Positive Returns
Even as rate cut expectations for this year have dropped from six in December 2023 to three,7 spreads continue to tighten on the heels of positive earnings growth and a resilient economy. And if those rate cuts occur, the looser policy could help minimize any funding concerns to keep risk-on and tight spreads.
Alongside strong income potential, there is a strong case for overweighting credit right now:
- Positive earnings growth, after a string of negative quarters
- A resilient economy, illustrated by a healthy labor market and upside surprises to GDP figures
- Looser policy, helping to offset potential re-funding concerns and margin pressures for highly indebted firms
Again, while tight credit spreads can produce positive returns, our historical analysis of the starting spread level and the subsequent 12-month returns reveals mixed relationships. For investment-grade credit, there is just a 38% correlation between the two data points, while there is a 57% correlation for high yield.8 For IG corporates, tight spreads don’t mean a sell-off is imminent (Figure 4).
Figure 4: Starting Spread Levels versus Subsequent 12-month Returns Reveals Mixed Relationships
Examining spread ranges and subsequent returns lends more insight into when starting spread levels matter most. For instance, when spreads are extremely wide, credit tends to have the strongest subsequent returns of any other starting spread level. This makes intuitive sense as these events typically occur during a market crisis when there is a severe dislocation to underlying fundamentals.
But this relationship doesn’t hold when spreads are at very tight levels — as they are close to now. Rather than showing a linear relationship, with the lowest returns when spreads are in the bottom quintile and the best returns when spreads are in the top quintile, returns show more of a “smile” pattern (Figure 5). In fact, quintile one’s (today’s) starting spread level returns are higher than quintiles two or three for IG corporates and high yield.
Credit Can Play a Role in Portfolios Despite Tight Spread
The current spread environment reflects the “goldilocks-esque” nature of markets: a resilient and growing economy coupled with positive corporate growth and slowing inflation juxtaposed with the potential for looser monetary policy. Yet, given the current spread levels, returns are more likely to come from the yields — especially valuable given today’s elevated yields of 5.4% for IG corporates and 7.8% for high yield — and not so much from further spread compression.9
Expressing an overweight to credit can take many forms. Given the level of rate volatility in the marketplace, having an actively managed credit exposure may be beneficial. You might also consider a more duration-balanced investment-grade corporate bond exposure rather than a broad corporate exposure. For example, a 1-3 year or 1-10 year maturity investment-grade corporate bond exposure has a far more balanced yield-to-duration ratio than the asymmetric ratio of broad corporates (2.9 and 1.3 versus 0.78).10
For more insights on the fixed income market, check out our views on active bond ETFs and fixed income portfolio construction ideas.