Junk bonds, also known as high-yield bonds, have been a significant player in the fixed-income market for quite some time. These bonds offer higher yields than investment-grade bonds, compensating investors for their increased risk.

However, the story of junk bonds has its challenges. Despite historically low credit spreads and outperformance in the face of deteriorating macro conditions, widening credit spreads on a re-evaluation of default risk is a legitimate concern. Clearly, the corporate credit event didn’t happen this year, but one thing I can say with confidence is that credit spreads tend to be riskiest when they are the narrowest.

One of the key factors contributing to the outperformance of junk bonds has been these historically low credit spreads. Credit spreads represent the additional yield investors demand for taking on the increased risk associated with investing in non-investment grade bonds. In recent years, these spreads have been unusually tight, reflecting a market environment characterized by strong investor demand and low default rates despite the fastest rate-hike cycle in history.

Only a Matter of Time

Despite deteriorating macro conditions in terms of bankruptcy filings rising in 2023, junk bonds have managed to outperform due to the support provided by low credit spreads. The anticipation of easier monetary conditions in 2024 has further bolstered the appeal of these bonds, as investors continue to search for yield in a what many hope will be a coming low-interest-rate environment. The problem here is that credit spreads tend to mean-revert over time, and if the Fed did overtighten, it’s only a matter of time for default risk to rise in junk debt.

While junk bonds have been thriving in the United States, the European high-yield market tells a different story. High yield spreads in Europe have been expanding, indicating growing investor apprehension about the creditworthiness of European issuers. This divergence between the U.S. and European markets highlights the potential fragility of the junk bond story. Widening credit spreads in Europe may serve as a warning sign for the global junk bond market.

The widening of credit spreads is a major concern for investors holding junk bonds. As credit spreads widen, the yield differential between junk bonds and safer assets such as government bonds increases. This can lead to a decrease in the attractiveness of junk bonds, potentially triggering a selloff and driving up borrowing costs for high-yield issuers. Furthermore, a meaningful widening of credit spreads next year could undermine the risk-on sentiment that has prevailed to close out the year, potentially causing a shift toward risk-off.

The Bottom Line

The story of junk bonds has been one of resilience and outperformance in the face of deteriorating macro conditions this year. Historically low credit spreads have supported the market, attracting investors seeking higher yields. However, the expansion of high yield spreads in Europe could be foreshadowing significant risks for junk bonds in the United States moving forward.

A credit event may yet come.

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.