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Credit spreads explained: how they affect markets   By Michael Chou Investment Manager

Michael Chou, UFS Investment Manager, explains why conditions in bond markets can be a good barometer for the health of markets as a whole. When global markets are turbulent, investors often begin to hear more about credit spreads. Credit spreads are widely considered to be a good barometer for the state of an economy because they track investor confidence and the market’s perception of risk.   Credit spreads reflect the difference in risk exposure when investors lend to corporates instead of governments. They are measured by the difference in yield between two bonds of a similar maturity and differing credit quality. Typically, lower risk bonds such as those issued by governments are compared against higher risk bonds such as corporate bonds.  Spreads are usually expressed in basis points, where 100 basis points equal 1%. Let’s take the example of a 5-year US corporate bond that is yielding 5%, while a comparable 5-year US government bond yields 3%. The spread between the two would therefore be 200 basis points.    What influences credit spreads? Credit spreads help to show the additional return investors demand for taking on extra risk. When economic conditions are difficult, credit spreads usually increase. This is due to the underlying risks of investing in bonds, which are liquidity risk and credit risk.   Higher risk bonds are generally less liquid than government bonds, meaning they cannot be bought or sold as easily, particularly in down markets. Investors also look at credit risk, which is the risk that corporates will default on their debt repayments. When market risks increase, the risk of corporate defaults also rises. Historically, governments in developed nations such as the US have not defaulted on their debts, which from a credit risk perspective makes them a much safer bet.  The perceived risk of a corporate bond is also affected by where it sits in the capital structure, which signifies the payment rank of an investor in the event of default. Senior (or investment-grade) bonds are higher in the capital structure, so would typically offer a lower yield than subordinated (non-investment grade) bonds, which are considered risky and more speculative.  Credit spreads can also be influenced by monetary policy. When central banks raise interest rates, borrowing costs rise and economic growth slows. At such times credit spreads typically widen. Conversely, during periods of monetary easing credit spreads often narrow as the operating environment for corporates improves. At such times there are often greater fund flows into corporate bonds.  Why do credit spreads matter? Historically, credit spreads have served as a useful indicator of economic strength or weakness. A widening in spreads is often a precursor to a downturn in the share market, while a narrowing in spreads shows conditions are improving for investors.  The ICE BofA US High Yield Index is a common bond index which allows investors to monitor the spread environment. Investors can view spread movements through FRED, the St. Louis Federal Reserve Economic Data website.   The following chart shows the movements in spreads since 2008.        In addition to the large spike in spreads during the global financial crisis (GFC) in 2008, the chart also shows increases in spreads following the 2011 sovereign debt crisis, the Chinese equity market crash of 2016, the global Covid-19 pandemic in 2020 and the start of the Russia-Ukraine conflict in 2022.  During these times, not only did risks increase in bond markets but equity markets were also hit by these market shocks. For these reasons, credit spreads are not only an important measure of the health of bond markets but of global markets more broadly.    Where are we now? Recently credit spreads in high yield credit and loans have been at historical lows, indicating corporate health and a competitive lending environment, driven by global monetary easing.  However, risks are beginning to increase following a recent spate of high-profile defaults in the US, including car parts manufacturer First Brands and auto loans company Tricolor.  According to our asset consultants JANA there is currently a portion of the market that is under stress – mainly those corporates that borrowed at ultra-low rates and then saw rates increase rapidly in recent years. In JANA’s view, we are also heading into a slower period of growth with some pockets of consumer weakness becoming apparent.   However, the fundamentals for the majority of the credit market remain strong. Credit managers are therefore expected to stay invested, albeit with slightly higher credit quality and slightly shorter duration assets than before.  As managers reduce risk exposure in bond markets, this is also expected to feed through to asset allocations in general as investors take profits and re-assess their positions. Currently, our bond portfolios across our Funds are defensively positioned, with the majority of investments focused on high quality investment-grade exposures.      The Uniting Financial Services (UFS) unregistered managed investment schemes are available for investment only to wholesale investors. Prospective wholesale investors who wish to invest via our unregistered managed investment schemes can access the Information Memoranda for any of these funds on the UFS website. Certain statements in the report may constitute “forward-looking statements.” These statements involve subjective judgment and analysis and reflect UFS’ expectations. Such statements are subject to significant uncertainties, risks and contingencies outside the control of UFS, which may cause actual results to vary materially from those expressed or implied. You are cautioned not to rely on such forward-looking statements. While the information in this report has been prepared with all reasonable care, UFS accepts no responsibility or liability for any errors, omissions or misstatements however caused. No action has been taken to register or qualify these products or otherwise permit a public offering of these products in any jurisdiction outside Australia. Past performance is not indicative of future performance. 

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