The Rise of Credit Interest

In recent times, a common question from investors has been, “What about spreads?” Following a long period of low interest rates, particularly from 2009 to 2021, there has been a noticeable shift in investor focus towards credit since interest rates began their upward trajectory in 2022.

Before the Federal Reserve initiated its rate hikes that year, high-yield bonds typically offered yields around 4 percent. However, as economic uncertainties grew, especially fears of a recession, the average high-yield bond spread expanded, moving to over 4 percent and elevating overall yields to approximately 9.5 percent by late 2022.

Evaluating Risk vs. Reward

Current yields have provided substantial returns for investors, spurred by increased demand for non-investment-grade credit and reduced recessionary fears, which have also seen bond values rise. Today, the average yield to maturity for high-yield bonds hovers slightly above 7 percent.

The essence of evaluating credit spread hinges on assessing default risks. Typically, investors will seek wider spreads as a buffer against rising defaults. Therefore, understanding the likelihood of defaults becomes essential. For instance, if high-yield bonds yield 8 percent compared to a 5 percent Treasury note, the decision is influenced by the associated default risk, which can be quantitatively assessed.

Reassessing Historical Norms

The vital consideration is not just whether present spreads are narrow compared to historical measurements but whether they adequately compensate for potential credit losses. Notably, today’s average spread of about 2.9 percentage points can effectively cover the historical annual credit loss rate of approximately 2.3 percent associated with high-yield bonds.

• Historical loss rates may be skewed due to unique crises.
• Central banks have introduced counter-recessionary measures to stabilize markets.
• Many bonds currently hold higher credit ratings, with over half rated BB or above.
• Active portfolio management can further mitigate default risks.

Considering these elements, apprehensions regarding narrow spreads appear overstated.

Short-term Volatility vs. Long-term Gains

It’s essential to recognize that spread fluctuations are often short-lived, akin to stock market volatility. A widening spread may lead to a temporary decline in bond prices; however, investors continue receiving their contractual interest payments. Assuming proper performance, bonds will eventually mature at par value, yielding the expected returns despite interim price variations.

Comparative Advantages of Credit Investments

Investors should also bear in mind an alternative in equity markets. The current elevated price-earnings ratios for major equity indices such as the S&P 500 suggest limited potential returns in the upcoming decade, compelling some analysts to forecast minimal growth.

In contrast, the returns on credit investments appear more favorable. Even with the recent softening in returns caused by shifts in market sentiment, high-yield bonds present attractive absolute returns compared to equities, exhibiting less unpredictability.