Credit Spreads - Dancing on Glass

Summary

Corporate bond yield spreads vs. Treasuries are currently at the tightest (lowest) level in 20 years. The last time spreads were at this level was the period immediately preceding the Great Financial Crisis (GFC) in 2006. When spreads trade at record tights, it is the direct result of market complacency and an overreach for yield.

Key Points

• Yield spreads act as a key indicator of economic health and market sentiment.
• The current spread of 73 basis points indicates extreme market complacency and is statistically 3σ (three standard deviations) below the mean spread width.
• Historically, tight IG spreads have signaled danger, with the last occurrence in 2006 just prior to the Great Financial Crisis (GFC).
• The long-term historical average for IG spreads is 132 basis points, leaving equity markets with virtually zero margin for error regarding unexpected inflation spikes, geopolitical shocks, or corporate earnings misses.
• High yield credit spreads are also severely compressed, with the current spread of 2.78% (278 basis points) indicating a highly aggressive market environment.