Appearances can often be deceptive, and nowhere is this more true than within the bond market.
Despite all the evidence pointing toward underlying economic strains, credit spreads remain at historically low levels. This presents a façade of stability and low risk.
Ultimately, the time to worry about default risk is when no one else seems to be worried about default risk. We are near that point now when it comes to junk debt.
Credit spreads, the difference in yield between U.S. Treasurys and corporate bonds of the same maturity, are a crucial indicator of the perceived risk in lending to corporations. When spreads are low, it implies a high level of confidence among investors regarding the ability of corporate borrowers to meet their debt obligations.
However, this confidence may currently be misplaced. High yield spreads, which provide insight into the riskier segment of the bond market, typically reach or exceed the 6% level during tumultuous economic periods. Presently, they are far below this threshold, suggesting an underestimation of risk that could lead to significant losses, particularly in junk bonds, should market conditions shift.
It is perplexing. On one hand, metrics such as GDP growth, unemployment rates, and the performance of major stock indices like the S&P 500 and Nasdaq 100 paint a picture of robust health. This narrative, perpetuated by financial media, suggests an economy and a market operating at full throttle. However, a closer examination reveals a different story.
The current low levels of credit spreads are a mirage, obscuring the brewing storm in the financial markets. Several factors contribute to this:
- Inflation Concerns: Rising inflation could prompt central banks to tighten monetary policy sooner than expected, leading to higher interest rates. This would increase the cost of borrowing and could precipitate a repricing of risk in credit markets.
- Geopolitical Tensions: Escalating geopolitical conflicts can lead to increased market volatility and a flight to safety. In turn this will widen credit spreads and impact the riskiest segments of the bond market.
- Corporate Indebtedness: The pandemic led to a surge in corporate borrowing, leaving many companies with elevated levels of debt. As interest rates rise, the burden of servicing this debt could become unsustainable for some, leading to increased defaults and wider credit spreads. This alone is why as I keep saying, small-cap stocks hold the key.
Yes, we are in a risk-on condition now. But just remember that while the financial media may paint a picture of an economy and market firing on all cylinders, a closer look reveals significant distortions and underlying risks.
The current complacency in credit markets, reflected in historically low credit spreads, is particularly concerning. I still believe credit spreads can blow out and sooner than people think.
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.