Are Extremely Tight U.S. Credit Spreads Underpricing Risk?

For investors, the narrowness of spreads means that they might be facing asymmetric returns with greater downside than upside potential.  Hypothetically, if spreads were to remain unchanged, the return to investors in high yield bonds would be equivalent to the return of a U.S. Treasury plus 2.56%.  Unless credit spreads narrow further to levels never seen previously, it’s difficult to see how investors in high yield bonds could outperform Treasuries by more than about 2.5% per year.  By contrast, if spreads were to widen, investors could see high yield bonds sharply underperform Treasuries. Indeed, during past economic downturns, spreads have widened to between 10-18%, leading to steep drawdowns of anywhere from 13% to 35% (Figure 2).

So why are credit spreads so narrow?  And what might cause them to widen? One answer is that the U.S. has been through a period of extremely rapid growth in nominal GDP (Figure 3).  Very few people look at nominal GDP, preferring the more widely followed inflation-adjusted real GDP.  

Nominal GDP is key to understanding credit spreads because it represents the amount of cash available in the economy to service debts, both public and private. Faster growth in nominal GDP means that more cash is available to pay coupons and principal on bonds. 

Coming out of the pandemic, not only did the economy experience strong real growth, it also experienced a period of exceptionally high inflation that topped 9% by 2022 and remains at around 3% currently.  Inflation makes the lives of consumers difficult.  For debtors, however, inflation can be beneficial, at least in the short run, because inflation is a form of default: all borrowers, be they public or private, can reimburse their debts with money that is worth less than when they took those loans.  And when the nominal GDP is growing quickly, that money is abundant. 

However, when nominal GDP growth slows, spreads can widen significantly.  During the tech wreck recession, for example, nominal GDP slowed from a 5-7% pace of growth to 2-2.5%.  That was enough to send the Bloomberg High Yield OAS spread over Treasuries from sub-3% in the late 1990s to around 10% by 2002.

What happened during the global financial crisis was even more dramatic.  Nominal GDP growth slowed from the 5-7% seen from 2003 to 2006 to -3% by 2009.  High yield spreads blew out to 18% over Treasuries delivering a 35% drawdown to high yield bond investors even as the prices of U.S. Treasuries soared.  Likewise, early in the pandemic, nominal GDP briefly contracted by 7% YoY, which corresponded with a sharp widening of spreads (Figure 4). 

Nominal GDP can present a challenge to investors as the data is not released until after the quarter ends.  Moreover, investors in credit products often anticipate changes in both real and nominal GDP slightly before they happen. Widening credit spreads may in fact cause economic downturns by cutting off the supply of capital to companies, which in turn respond to deteriorating financial conditions by postponing investments, cutting back on spending and laying off staff.  From this perspective, today’s narrow credit spreads may be pointing towards continued solid growth in coming months.

For a higher frequency view of nominal GPD, one can look at the monthly U.S. employment report.  Normally, the report is viewed in terms of its component parts: the monthly change in non-farm payrolls, the annual change in average hourly earnings, and the number of hours worked. However, conceptually, it makes more sense to look at these items in the same units, as a year-on-year percentage change, and chain them together to get the total labor income.  If total labor income slows below its current growth rate of 5% because of any combination of falling employment, slowing wage growth or reduced hours, it could signal that a spread widening is about to happen (Figure 5). 

Going into the global financial crisis, for example, credit card and auto loan default rates were on the rise well before the eventual widening of credit spreads took place. This time around, credit card 90+ day delinquency has risen to its highest level since 2011 while auto loan 90+ day delinquency is at its highest since 2010. This may be signalling an imminent slowdown in consumer spending and therefore a weakening of the pace of nominal GDP growth leading to a widening of high yield bond spreads (Figures 6 and 7). Indeed, U.S. retail sales for January surprised by coming in about 1% below consensus expectations. 

That said, not everything is worrisome on the household side. Mortgage loan delinquency remains very low, although it has been steadily rising since the end of 2021 (Figure 8).  Defaults on business loans (mainly to individual proprietorships) has also been very low, rising only slightly in recent quarters (Figure 9).

Lastly, there is the rapidly changing public policy environment. Investors managing risks to their portfolio need to closely watch the employment, consumer spending, and loan default numbers as the economy absorbs changes to federal spending and employment levels as well as the impact of tariffs.

What is clear is that the advent of futures on the Bloomberg U.S. Corporate High Yield Very Liquid Index, the Bloomberg U.S. Corporate High Yield Duration Hedged Index and their investment grade counterparts allow investors an exchange traded and centrally cleared means of managing their exposure to this sector. Given the possibly asymmetric return profile of these instruments, additional hedging mechanisms could be welcome news.