High Yield Spread hints of Market Exuberance?
The high-yield spread is also commonly known as the credit spread. It is the percentage difference in the current yields of various classes of US high-yield bonds (i.e., BB-rated or below junk bonds), as compared to US government bonds (spot US treasury curve). Many fixed income and stock investors monitor the high-yield spread to evaluate the credit markets and market sentiments.
The high-yield or junk bond spread represents the higher compensation investors afforded for taking the additional risk of buying junk bonds instead of treasuries. When the spread is low, it implies investors believe holding junk bonds offer nominal risk over holding treasuries.
The ICE and St. Louis Federal Reserve data (FRED) dating back to December 1996 shows the ICE BofA US High Yield Index Option-Adjusted Spread reached a record high of 19.88 in November 2008 and a record low of 2.46 in May of 2007.
The current high-yield spread at 3.32 (August 2021) is nearing the extreme lows corresponding to previous periods, including May 2007 (2.46), Feb 2005 (2.83), September 1997 (2.59). The junk spread today is also well below the 25-year average of 5.5 percentage points.
Since the mid-1990s, there have been only two other occurrences when the junk spread traded as low as it is today - before the bursting of the Tech/telecom bubble, and the credit/real estate/financial crisis.
Although the credit markets today are relatively stable, investors may be showing early signs of exuberant behavior, as evidenced by the junk bond spread trading near its historical lows. The current low high-yield spread is not likely to stay at these levels for much longer. It is difficult to determine if another economic crisis is developing. But when high-yield bond spreads have fallen to extreme lows, it has led to financial crises and subsequent economic downturns.
However, there were two other occurrences when the spread traded to today's level during June 2014 (3.53) and again during January/September 2018 (3.29/3.28). Both times the spreads widen but this did not lead to economic distress or a business contraction.
Assuming history does not repeat itself, but it tends to rhyme, it is reasonable to expect the spread will eventually return to its 25-year average of 5.5. An economic recession does not appear likely based on the accommodating monetary policies and the massive government stimulus programs.
Nonetheless, it would be worrisome if the spread suddenly double or triple overnight. If the junk spread did indeed widen dramatically, then many companies with less than stellar debt ratings would struggle to service their debt-service costs despite a historically low Treasury yield environment. Can this lead to a credit crisis and possibly to the next economic contraction.
Will the high-yield spread become increasingly important as both a leading indicator of US credit/economic conditions as well as a gauge to speculative market behaviors ahead of major market tops.