There is a plethora of economic indicators, but few carry as much weight as the 10Y corporate high yield spread (CBUS10YRSPREAD); while it isn’t flashing red just yet, it is beginning to signal potential danger.
There is a plethora of economic indicators, but few carry as much weight as the 10Y corporate high yield spread (CBUS10YRSPREAD); while it isn’t flashing red just yet, it is beginning to signal potential danger.
The spread measures the extra yield demanded by investors on corporate high yield bonds relative to US Treasuries. A widening spread usually reflects greater uncertainty while a tightening spread indicates greater economic confidence. During the height of tariff panic, credit spreads reached a high of 4.48—an increase of 1.77 points from the January low. With trade tensions gradually decreasing since then, high yield spreads reversed down to previous levels below 3.0, signaling increased appetite for risk among investors. That all changed this month when the indicator reversed into a column of Xs for the first time since March. With the indicator serving as an important window into the health of financial markets and the economy, should we expect the worst, especially with the recent decline in long-term participation?
To answer that question, we examined previous instances where CBUS10YRSPREAD reversed into Xs. Historically, these reversals led to further widening of spreads, with the average move lasting 62.4 days and gaining 0.30 points. When credit spreads are at historically low levels, there’s only so much lower for them to go, so reversals from low levels can be even more precarious for high yield investors. There have been eight instances where high yield spreads reversed from a chart level below 3, during which the credit spread has grown by an average of 44% over the next year. While the indicator might maintain or move below current levels, few environments have seen extended periods of spreads this low, so the path of least resistance remains higher for the time being.
A further widening of credit spreads would act as a headwind for high yield bonds, as existing high yield bonds would become less attractive to newly issued ones offering greater yields. Additionally, we’ve already seen signs of relative deterioration within the group. The iShares iBoxx High Yield Corporate Bond ETF (HYG) holds a fund score of 2.71, which is below the 2.90 fund score of the iShares US Core Bond ETF (AGG) for the first time since April of this year. Investors looking to adjust their high yield allocation could consider other areas of strength within the asset class, such as convertibles and international fixed income.
Recent anxiety within credit markets has also sent ripples across the financial sector, with the group seeing significant change so far in October. Financials have lost 10 signals in DALI’s sector ranks this month, causing the group to fall behind Industrials for the fourth spot. While the sector remains an overweight area, the group is back to its lowest rank since May of 2024. However, downside within Financials has come disproportionately from select areas of the sector.
Specifically, non-mega cap banks have weakened in recent weeks, as they’re more at risk of worse credit conditions due to their reliance on traditional lending for income. Most recently, Zions Bancorporation (ZION) and Western Alliance (WAL) tanked last week after announcing issues with some of their loans, scaring the broader credit market. As a result of these and other events, the SPDR S&P Regional Banking ETF (KRE) is down 9.6% over the last month, moving back to a sell signal while now testing its bearish resistance line. Meanwhile, the group’s strength was cut in half, as KRE’s fund score of 2.11 is down 2.43 points from its peak in September. Additionally, banks with less reliance on traditional banking have fared much better, with many of the largest names continuing to move higher. In contrast to KRE, the Invesco KBW Bank ETF (KBWB) holds a strong fund score of 5.27, highlighting the superiority of biggest names.
As credit conditions evolve, the high yield spread remains a critical gauge of investor sentiment and economic health. Whether this reversal marks the beginning of a broader shift or a temporary blip has yet to be seen. In the meantime, investors should continue monitoring the latest relative strength developments for signs of confirmation in either direction.
