Stock markets often grab all the headlines, but savvy investors know the bond market should not be ignored as it can provide early warnings of investor anxiety.
A key indicator to understand is the ‘credit spread’ which measures the extra yield that investors demand to lend money to companies, rather than governments.
Recently, spreads on both investment grade (firms assessed to have good credit quality) and high yield (firms with lower credit quality) bonds have started to widen, suggesting investors are becoming more nervous.
Widening spreads can indicate concern about economic growth, corporate finances or market volatility.
What is a credit spread?
The credit spread is the difference between government bonds yields and corporate bond yields. Currently, 10-year UK government bonds yield around 5.4% while corporate bonds yield 6.3%, so the credit spread is 0.9%.
Government bonds from developed countries like the US and UK are generally safer than corporate bonds which have a higher risk of default under certain circumstances, and the 0.9% extra yield is the spread that investors demand for compensation.
It’s a bit like lending money to a friend who has a stable job versus a friend whose finances are less certain.
What is the difference between investment grade and high yield?
Companies which have stronger finances can borrow money from investors more cheaply than those with weaker finances.
The corporate bond market is roughly divided into investment grade (good quality) and non-investment grade issuers, with the latter sometimes referred to as high yield, or junk bonds.
As the name suggests, these firms have weaker finances, more debt and often operate in more cyclical industries, all factors which makes them vulnerable during periods of rising interest rates and economic recession.
This feature makes high yield bonds riskier than investment grade and government bonds.
For these reasons, the high yield bond spread is wider than the investment grade yield spread, at roughly 3.3% above government bond yields. One of the broadest indices tracking high yield issuers is the iBoxx USD Liquid High yield index.
When you look at the companies classified as high yield, you will still likely be familiar with many of the names. Just because a company issues high yield bonds, it doesn’t necessarily mean it’s ‘bad’, it just means its credit is rated less highly than others in comparison. The high yield index mentioned above, for example, includes euro-dominated high yield bonds from companies like Virgin Media and US AI data centre provider Coreweave.
Why have spreads been widening?
Until the recent widening, bond yields were proving attractive to buyers which has kept credit spreads at historically tight levels, with credit fears remaining relatively contained.
That has changed in the last couple of weeks as rising government bond yields, growing inflation fears and record issuance of investment grade debt have pressured credit spreads.
What is particularly noteworthy is that high yield spreads have underperformed investment grade spreads. And within high yield, lower credits have underperformed, suggesting rising concern that higher rates are causing financial stress.
Bond analysts at Nuveen believe recent spread widening reflects a market repricing rather than distress in credit markets, as markets digest record levels of corporate debt issuance, surpassing the prior peak set in 2021.
While that sounds like a positive take on recent developments, Nuveen also warns of trouble ahead if spreads continue to widen: “If spreads keep widening at the lower-quality end, we would start to worry that higher rates are biting beyond valuations and into companies’ ability to refinance.”
How bond funds can help
It is easier for most retail investors to invest in bond indices rather than choose individual company bonds, which requires knowledge and judgement about a specific company’s credit quality.
Passive exposure to corporate bonds can be achieved by investing in ETFs (exchange-traded funds) which track diversified indices such as the Iboxx Liquid Corporates Large Cap index, which is comprised of hundreds of investment grade bonds issued by companies, including Tesco, HSBC and Lloyds.
Martin Gamble: Shares and Markets Writer
Martin Gamble is Shares and Markets writer at AJ Bell. He was previously the Education Editor of Shares Magazine. He has been with the business since 2019.
Martin graduated from the University of Kent in...