Understanding credit spreads and their implications is crucial for any investor seeking to navigate the complex world of bond markets. The time to worry about credit spreads is when they become too narrow, like right now.

Despite increasing consumer credit defaults, resumed student loan payments, and escalating corporate bankruptcies, investors appear to be demanding less yield for junk bonds despite the debt issuers facing increased credit strain. A credit event would shock those investors back to reality.

What Are Credit Spreads and What Do They Mean?

Let’s understand what credit spreads are. A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. Investors monitor these spreads to gauge the risk associated with a particular bond. When the spread narrows, it indicates that the market perceives less risk. Conversely, a widening spread suggests higher perceived risk.

Historically, there is a strong link between credit spreads widening and stock market volatility. The implication here is simple.

In the same way volatility reverts to the mean when it gets too low for an extended period, the same holds true for credit spreads internally in the bond market.

Currently, credit spreads are remarkably tight, indicating a low-risk market perception. This frankly is outright bizarre given present economic uncertainties and the high-risk nature of junk bonds.

For instance, the risk of rising consumer credit defaults and the resurgence of student loan payments should logically lead to wider credit spreads. Moreover, an uptick in corporate bankruptcies typically augments the risk associated with junk bonds, warranting more substantial yields. However, the market seems to exhibit an oddly reduced concern about current credit conditions, evident in the demand for lower yields for junk bonds. This is precisely what should concern everyone.

One possible explanation for this is the robust state of corporate balance sheets. Despite economic uncertainties, many corporations have managed to maintain healthy balance sheets. This financial stability could be contributing to narrower credit spreads as investors perceive lower default risks.

The Bottom Line on Junk Debt

However, this does not negate the potential risks associated with increasing consumer credit defaults, student loan payments, and rising corporate bankruptcies. The yield curve, let’s not forget, is still screaming recession.

The tightening of lending standards, despite healthy corporate balance sheets, points to a potential credit event, combined with overseas risks and zombie companies that may not be able to survive higher rates when they roll over their debts. If risk appetite reverses, credit spreads could widen rapidly, leading to substantial losses for junk bond investors. A credit event focused on junk debt could lead to a significant market shake-up, affecting not only the bond market, but the broader financial market as well.

Current narrow credit spreads, despite a high-risk environment, should serve as a warning signal for investors that people could be surprised and get caught off-sides in a sudden and swift re-evaluation of default risk. Junk debt can only narrow for so long relative to high-quality paper in the bond market, and my concern is no one is prepared. Historically, the ratio of Treasuries to junk debt spikes. I suspect this happens soon.

On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.