Similar to the equity market’s response to the recently announced tariffs, the bond market responded with a widening of credit spreads. These spreads represent the difference in yield between a U.S. Treasury bond and other bonds of the same maturity but different credit quality. They are basically a measure of the additional compensation an investor demands for taking on the credit risk associated with a lower-rated bond compared to a Treasury bond. Corporate bonds, and especially high yield bonds, usually see a spread widening during periods of uncertainty, which is a normal market repricing of risk. However, this time we experienced a lot of news about disruptions in the bond market and comparisons to prior periods of distress in the credit markets. While spreads for risk assets in the bond market saw a sharp response, this recent impact was far from the distress levels seen in 2020 and 2008.
As the chart suggests, equity sensitive bond sectors, especially high yield corporates, tend to experience spread widening that is negative for prices alongside equity market drawdowns. This widening happens in steps and for several reasons. Initially, when negative news impacts markets, and especially when it is uncertain how the news will influence the creditworthiness of a bond issuer, investors pause and assess the risks. During the pause, we will see a period of illiquidity in the market and a large amount of spread widening as a component of risk repricing. At some point, buyers accept the new pricing, and a support level is established as the new fair market value is found. With the tariff announcements, we saw this happen in a bigger way than in normal market downturns because it was harder to quantify the impact on credit quality and default rates. Furthermore, the high yield bond market is rather small relative to the other sectors and consistently low default rates have led to more demand, and therefore tighter spreads for some time compared to historical levels.
A pullback in issuance around the time of the tariff announcements prompted a lot of discussion around distress in the bond market. Interest rate volatility during this time was a key factor in this as investment bankers pull back to ensure favorable pricing. Overall, the corporate bond market came through the uncertain environment operating as it should. This is vastly different from 2020 when the U.S. Federal Reserve had to step in and purchase corporate bonds to support the market and provide liquidity.
With low default rates and strong corporate balance sheets, companies entered the tariff environment in a strong position. We remain positive on investment grade corporate bond positions and look at periods of market volatility and spread widening as opportunities. However, there is risk to assess given the disruption tariffs present to some industries.
High yield issuers are especially at risk. Tariffs mean inflation and disruptions to business operations. Higher wholesale prices squeeze margins for many companies, and this impacts their creditworthiness as it has a direct effect on an issuer’s ability to repay debt. Thus the strong response to the tariff announcements. As tariff talks continue and we see some easing as deals are made, we see opportunities in actively managed high yield ETFs that are supported by strong research.
Negative rating activity has picked up in recent weeks relative to positive changes. While this is a concern, these have been concentrated in a few industries, such as consumer and building materials. Risks are definitely elevated and deserving of the recent repricing of risk, though we have not seen the structural or liquidity breakdowns of 2020 or 2008 in the credit markets at this point.
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Index Definitions:
Investment Grade Credit Spreads – These spreads are represented by the Bloomberg US Aggregate Corporate Average OAS, which measures the difference between the Index’s yield and the yield of a similar maturity US Treasury bond.
High Yield Credit Spreads – These spreads are represented by the Bloomberg US Corporate High Yield Average OAS, which measures the difference between the Index’s yield and the yield of a similar maturity US Treasury bond.
S&P 500 Index – This Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
