I was head of U.S. Portfolio Management for Sun Life Financial for twelve years. In that role I spent a lot of time worrying about interest rates and the fixed income markets. Whether it was corporate bonds, securitized assets, private debt or commercial mortgages, we always focused in on the “spread to treasuries” as the measure of ‘rich’ or “cheap” and relative value.
Credit spreads today are narrowing in on historical lows. Per the chart below from the Federal Reserve Bank of St. Louis, you can see that credit spreads for investment grade corporate bonds and high yield bonds are at 10-year lows of 0.80% and 2.72%, respectively. Though not all-time narrows, this secular shift down can be implying an important message to us.
Most thought leaders look at the narrowing of credit spreads as a positive indication of economic strength. Certainly, if businesses have good earnings and are well able to cover their debt service then there should be less chance of default. Thus, the part of the credit spread reflecting default risk would be reduced. Narrow credit spreads also reflect a supply and demand factor indicating increased demand for income-generating assets from investors.
This is good news for equities, too, since a narrower credit spread indicates reduced borrowing costs for debt issuers and improved net earnings. In this regard, equities and fixed income markets are on the same page; all-time highs in the equity markets and 10-year lows in credit spreads both reflect the same positive story.
This single data point supports the thesis that the “bull” case for capital markets remains strong. Anything can happen, of course, including geopolitical turmoil bubbling up overseas in Ukraine/Russia and Israel. As always, an investment strategy targeted to an investors risk tolerance and time horizon should help an investor achieve their goals.