A peculiar serenity in credit

Markets for corporate bonds are still remarkably loose, with yields that don't adequately offset risks

The investors are anxious. Other than reading the recent gold gains above £3,650 an ounce for the first time this week or the significant movements in long-dated government bonds, there aren't many other options. Some markets, however, appear remarkably unaffected.

Consider the difference in yields between corporate debt and government bonds, which have a tendency to blow out during stressful times.

Instead, spreads on US investment-grade bonds are as tight as they have been since 1998, only 0.8 percentage points (pp) higher than the yield on similar Treasuries. Similar to this, eurozone investment grade bonds are still very low despite occasionally being tighter (for example, in 2007 and 2018). Non-investment grade (also referred to as high-yield) bond spreads are currently about 2 points 9 pp, which is slightly higher than they were earlier this year in both the US and European markets. Nevertheless, they remain below the 4 percent-plus range they reached in April, which was not particularly high, and at the very bottom of their long-term range.

Private credit expansion.

According to one theory, the reason spreads are tight is because government bonds are becoming riskier and no longer provide a true "risk-free rate" against which corporate bonds can be measured. Given that the spread on US AAA-rated bonds is approximately 0 points and 3 points, some contend that premium corporate credit may trade on lower yields than government bonds.

I think this is a stretch. Central banks purchasing bonds at low yields, a precedent established by quantitative easing, is the most likely way for governments to get out of this situation. It is most likely inflationary, and low-yield corporate bonds will suffer from inflation. You should demand higher yields rather than accept lower ones if this is what you expect.

The argument that the corporate bond market is now of higher quality is another one that supports high yield. Because private credit has become the most popular alternative asset class in recent years, lower-quality borrowers have moved there in search of better terms. Better borrowers are now stuck with bonds as a result. Spreads continue to appear so tight that they don't offer much compensation for risk, though there may be some truth to this.

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Naturally, tight spreads also contribute to the allure of higher yields in private credit. Private credit presents a challenge because it is by definition less accessible, making it more difficult to get a clear picture of the market and the level of risk investors are taking in order to obtain, say, a 200 pp increase in yield from something much less liquid.

A recent study by ratings agency SandP Global claims that default rates are still low, at about 1%. However, this is based on a limited definition of default and does not account for selective defaults, such as extending debt maturities, converting cash interest into more debt, or taking repayment holidays. Even though the environment is benign, S&P claims that defaults have increased significantly when those are taken into account. Other analysts' data shows a similar picture. Since there will be a reckoning when the cycle turns, low bond credit spreads are a risky excuse to keep looking for higher private credit yields.