High yield spreads have widened recently, a potential sign of risk-off sentiment.
Recently, there have been signs that the appetite for credit risk is waning. Earlier this month the ICE BofA US High Yield Spread Index (HIGHYIELDSPREAD) reversed up into a column of Xs on its chart. Meanwhile, the other high yield spread index we track on the platform (CBUS10YRSPREAD) reversed up into Xs last month. Widening spreads have the same effect as rising interest rates—lower bond prices—and are therefore detrimental to bondholders. High yield bonds have already weakened due to the widening spreads; in the Asset Class Group Scores, the average score for the high yield corporate group has fallen to 1.90 from 2.40 at the beginning of September.
While high yield spreads have a direct impact on bonds. They are also regarded as a bellwether for the economy (or economic sentiment) and equities. When investors are worried about the possibility of recession and by extension that borrowers (i.e., bond issuers) won’t be able to service their debt, they demand a higher return for the increase in risk and high yield spreads widen. Conversely, when the economy is perceived as being strong, investors are more willing to lend and high yield spreads contract. In an extreme example, high yield spreads widened by more than 700 bps in March of 2020 amid fears of an economic collapse at the outset of the COVID-19 pandemic. Last year, CBUS10YRSPREAD rose about 180 bps in March and April amid tariff worries.
While the economy and the stock market are not one in the same, there is a typically a strong relationship between the two and US equities have historically performed significantly better when high yield spreads are narrowing, indicating favorable economic conditions. The table below shows the quarterly performance of the S&P 500 when high yield spreads are narrowing versus when they are widening. It is also apparent that the magnitude of the change is also significant as the S&P has performed better during quarters when spreads narrowed significantly and worse when they widened by a large amount.
The risk-off move in credit has not been limited only to high yield bonds. The graph below shows the price history of a Markit credit default swap (CDS) index. It has risen significantly since the beginning of September and is now the levels it reached in March at the outset of the Iran conflict. The increase reflects greater demand for credit default swaps, suggesting that the market is more concerned about borrowers being able to service their debt obligations than it was a couple months ago. That concern has been cited as the reason that some AI-related companies, like CoreWeave (CRWV), have seen significant drawdowns recently. Ironically, worried investors may make it more difficult for these firms to service their debt as widening spreads drive up their borrowing costs. The upshot is that if we continue to see credit tighten it could be a headwind for firms borrowing to finance the AI buildout.
The practical implication of this relationship is that even investors without corporate debt exposure should an eye on credit spreads. Widening high yield spreads are generally correlated with muted returns while narrowing spreads have historically been associated with a stronger equity market. Like widening spreads, rising CDS prices reflect a more risk-off posture in market and as CRWV has shown recently, that isn’t a concern only for debt holders.
We don’t want to overblow the significance of the reversals on the charts of HIGHYIELDSPREAD and CBUS10YRSPREAD as you can see there were other reversal in the last year that were ultimately short-lived. Like any other indicator, every chart reversal won’t end up being meaningful but movement in high yield spreads and other credit instruments can be a useful data point for diagnosing the state of the market.
