Is credit score cruising for a bruising? | USAEMALL.com

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US stocks are queasy, economists are morose, data keeps worsening and even Treasury Secretary Scott Bessent can’t rule out a recession. But one widely followed indicator remains relaxed: high-yield bond spreads

This matters because credit markets are often seen as more accurate harbingers of economic distress than happy-go-lucky stonks. Junk bond spreads famously sussed out the severity of Covid-19, the global financial crisis, the dotcom bust and the Russian financial crisis of 1998 far earlier than the gormless equity market.

And while credit has certainly taken a hit lately (as we noted yesterday), it has been far more resilient than equities, indicating that credit investors still think a recession is exceptionally unlikely. Here’s what junk bond spreads have done lately.

As you can see, spreads have noticeably widened this year, but at just 325 basis points they are still far below both the near term and long term averages, and the 500-600bps seen at the peak of the 2022-23 growth scare (which in retrospect seems comically overdone).

To put it plainly, these are not levels that indicate that credit investors are unduly worried about a marked uptick in corporate defaults that a recession would entail.

Why then the severe stock market’s wobble? Well, that is easily explainable as a reflection of AI froth abating and tariff drama dampening the upside for many other stocks. Dwindling optimism on earnings is bad for stocks, but can be good for credit if it pushes companies into being more cautious.

Nonetheless, there are a few analysts now arguing that the strength of credit markets should not be over-interpreted. Here’s what Morgan Stanley’s Andrew Sheets wrote yesterday, with his emphasis below:

We’re mindful of the temptation for equity investors to take comfort from the credit market’s resilience. Yet remember, two of the big issues that have faced stocks (the lower chances of animal spirits and heavy concentration in similar names) were not really credit stories. To feel better about those risks, you’ll want to look elsewhere.

What about the risk in the other direction, of credit catching up — or down — to the stock market? This is all about that third factor — growth. If the growth data hold up, credit investors will feel justified in their more modest reaction, as demand and all-in yields remain good.

But if data weaken, the risks to credit grow rapidly, especially as our US economists think that the Fed could struggle to lower interest rates as fast as markets currently expect it to. Credit was much less resilient last week, and EU credit has actually underperformed equities to a pretty large degree. Credit’s ‘resilience’ clearly has limits, especially as growth fears come to the fore.

In other words, credit is less panicky than equities, but it is starting to lose its cool, and if the data keeps weakening then spreads will start to balloon further.

However, there could also be some interesting technical factors at play here. Greg Obenshain of Verdad Capital reckons that the private credit boom might have muffled the signal the credit markets have reliably sent ahead of previous economic downturns.

He points out that the US high yield market has stagnated in size and increased in quality over the past decade, as many riskier corporate borrowers have shifted over to private credit markets. Alphaville’s emphasis below:

The numbers are staggering. While the Bloomberg High-Yield Index has about $1.4 trillion of bonds, it is matched by the leveraged loan market with $1.3 trillion of loans, according to Fitch, and is now exceeded by private credit lenders with as much as $2 trillion of private credit assets, according to McKinsey. While the private credit market has experienced rapid growth in the past ten years, the high-yield market is the same size as it was in 2014.

Furthermore, over the same period, the share of BBs, the highest-rated portion of the index, has climbed from 41% to 51% of the high-yield index. The high-yield market has gotten safer as private markets have removed risky borrowers from high yield and expanded the pool of risky borrowers in the private credit market.

Obenshain still reckons that high yield spreads remain a valuable indicator, pointing out that even über-junky triple-C rated junk bond spreads are still modest even after the recent rise (and that lower-rated debt is not actually a better harbinger).

He argues that, overall, the high yield spread signal is “not broken”, merely a bit different.

It has correctly reflected a positive macroeconomic environment, and so far, it has been right. So where are we now? Spreads are low, and they may be rising. This does not signal an imminent crisis, but it does move us to an environment where equity returns have been lower on average.

Nonetheless, the private credit argument sounds persuasive to Alphaville. You might think it’s just a convenient bogeyman for us, but think about it for minute.

With an average coupon of about 6.4 per cent, the US junk bond market throws off almost $90bn of cash a year, which investors mostly need to reinvest in a market with no net supply for almost decade. It seems very plausible that this technical bid would contain spreads beyond where the fundamentals warrant, even setting aside the shifting credit quality of the market.

And it’s not like the private credit market signal is looking much better . . . .