High-yield bond market shows rising credit risk as spreads widen

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High-yield bond credit risk

Highlights

High-yield bond market yields rose to 8.1% from 7.22% over the past month amid stronger inflation pressures and a nearly $2 trillion U.S. deficit.
Credit spreads in the high-yield market widened to 315 basis points, signaling rising perceived credit risk compared to a year ago but below March's 346 basis points.
Spreads for CCC-rated and below bonds jumped to about 1,250 basis points, reflecting investor caution, while BB-rated bonds now make up over 60% of the market.

Yield and spread signals draw investor scrutiny

As reported by CNBC, yields in the high-yield bond market have climbed to 8.1% from 7.22% a month earlier as investors price in stronger inflation pressures from high energy prices and other factors, including concern about the U.S. deficit, which reached nearly $2 trillion in the fiscal year that ended Sept. 30.

Credit spreads in the broader high-yield market have also widened to 315 basis points, a level above a year ago though still below the 346 basis points reached in March. Wider spreads indicate that investors are demanding more yield to hold corporate debt instead of Treasurys with similar maturities, reflecting a higher perception of risk.

Michael Arone, chief investment strategist at State Street Investment Management, says the market is "flashing yellow" but remains far from a more severe stress signal. He says the key issue is whether the move reflects a repricing of interest-rate risk or a deeper reassessment of corporate credit quality, while noting that earnings are still growing, interest-coverage ratios remain healthy and default rates, although higher, are not yet alarming.

Lowest-rated debt faces the biggest pressure

The most pronounced deterioration is concentrated in the lowest-quality slice of the market, where bonds rated CCC and below have seen spreads rise to roughly 1,250 basis points over the past year. That suggests investors are becoming more cautious toward debt with the highest probability of default as financing costs increase.

Kelley Gerrity, a fixed income strategist at Morgan Stanley Investment Management, says the overall high-yield market still stands on solid fundamental footing, with credit quality at a record high. BB-rated bonds now account for more than 60% of the market, compared with 38% before the global financial crisis, indicating that the market mix is stronger than in earlier periods of stress.

Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research, says the weakest tier of high yield has always been the most speculative part of the market, making its sharper spread widening less surprising. Even so, the recent move suggests investors are likely to stay selective rather than abandon the asset class altogether.

In our earlier article on U.S. broadly syndicated loan CLO metrics, we noted a mild deterioration in index readings as the share of 'CCC' assets rose to 5%, the highest level of the year. Even so, overall credit quality and default exposure were described as broadly stable, while pressure was building in junior CLO tranches due to weaker cushions, par-loss trends, and loan-price bifurcation.

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