The Impact of Credit Spreads on Fixed Income Investments
Credit spread, defined as the yield minus that of a risk-free Treasury bond of equivalent maturity, indicates investors’ perception of default risk associated with any bond. Spreads may widen or narrow depending on a variety of factors.
Hard economic times tend to widen credit spreads. By studying the relationship between initial spread levels and subsequent returns, investors can spot opportunities within the fixed income market.
Yields
Yield spreads represent the additional compensation investors require when taking on corporate bond default risk instead of purchasing usually lower-risk Treasury bonds. They are calculated by subtracting the yield on one from the yield on another, often seen as an indicator of investor sentiment and economic conditions.
Credit spreads that are tightly traded can provide investors with strong returns; however, investors should remember that macro factors and yield levels have more of an effect than just their individual impact on how spreads move in terms of direction and volatility.
Current market conditions of steady inflationary pressures and strong economic growth have helped keep investment-grade corporate bond spreads tight and produced positive excess returns for active managers. We constantly assess both relative and absolute spread positions to determine how best to position our portfolios.
Price
Yield spreads between investment-grade corporate bonds and 10-year Treasurys are one of the key indicators for measuring investor sentiment, economic health and bond market dynamics. They represent investors’ expectations regarding additional yield that comes with taking on credit risk from corporate bonds instead of going with relatively risk-free Treasurys.
As the perceived default risk of a bond increases, so too does its credit spread. Conversely, when economic conditions remain stable and investors remain confident about corporate earnings, spreads narrow significantly and their all-in yield on investment grade corporate bonds is typically reduced.
Today, the all-in yield for the IG Corporate Index stands at approximately 4.78% with a credit spread of 55 basis points compared to 496 basis point spreads that prevailed before COVID was introduced.
Liquidity
As with most fixed income investments, most fixed income investments involve some credit risk. Investors are compensated for this risk through yield spread increases that correspond with higher levels of risk. It is crucial that investors find an equilibrium between their need for sufficient yield and taking on too much credit risk.
Corporate bond yield spread is defined as the difference between its yield and that of similar government securities (expressed as a percentage), and represents additional yield needed to compensate investors for perceived higher default risk, relative to investments typically risk-free Treasury securities. Furthermore, this indicator of market sentiment also acts as a barometer; wider spreads indicate fear and instability while tighter spreads suggest confidence and stability – and historical analysis has demonstrated this is often influential on future returns.
Risk
Credit spreads represent the risk that a bond issuer will default on its interest and principal payments (along with any credit enhancements), making up one component of bond returns. Savvy investors recognize that spreads can vary both relative to each other as well as absolute.
Yield spreads–or the additional compensation investors demand in order to hold corporate bonds over Treasurys–are an accurate gauge of investor sentiment and economic conditions. Narrower spreads signal investor optimism while wider ones can reflect concerns over its health.
As government bond yields have steadily climbed to near 2024 highs over the last year, many investors assume that credit spreads are similarly tight–but this may not be accurate. Unlike broad-based bond market indexes, high yield bond adjusted credit spreads can become highly distorted when seen at ratings bucket, sector subsector or issuer levels.
