What does the chart show?
 
This chart shows the spreads on US corporate debt. Spreads, which are the difference between the yields on a fixed income security and the yields on the almost risk-free US treasuries, show the risk associated with that security. A wider spread indicates a riskier security, given that investors require higher yields, taking on greater risk of a firm defaulting, due to things like weaker balance sheets or when economic conditions are more difficult. US corporate debt is then divided into the two separate groups of investment grade (IG), which is considered lower risk and then the riskier high yield (HY) credit with their groups determined by ratings given by agencies such as S&P and Moody’s. The market’s interpretation of their relative riskiness can then be seen using credit spreads. US HY credit has an average spread of around 500 basis points (bps) with IG credit’s average spread closer to 150 bps. The spreads of both groups currently sit below their long-term averages with HY at 418 bps and IG at 124 bps.

 Why is this important?

 The recent perfect storm of higher interest rates, cooling economic activity, and the US banking crisis have resulted in extremely difficult credit conditions for US firms. The Federal Reserve’s Senior Loan Officer survey showed a significant proportion of banks were tightening up their standards for business loans and the firms that are able to take out loans will find their interest expenses greatly increased after years of easy money. The impact of these tough conditions is already evident with bond default rates and bankruptcies on the rise. If an inverted yield curve is once again a successful predictor of a recession in the US, default and bankruptcy rates are likely to worsen. Despite the issues facing US corporate borrowers, bond markets don’t seem to have got the message. Having risen throughout 2022 as recession expectations grew, the spreads on both IG and HY credit have fallen below their long-term averages, effectively suggesting that the outlook for these bonds is better than it normally would be. HY corporate borrowers with their weaker balance sheets, lower quality businesses, and more cyclical revenues are especially vulnerable to an economic downturn, and yet spreads have given no indication of any nervousness. Either corporate bond markets are unconvinced by the noise surrounding the likelihood of an impending recession, or they simply believe that US firms will be able to weather any difficult periods, possibly due to the expectations of fiscal or monetary support. There are also hopes that a future easing of credit conditions will relieve US firms of any real pressure from higher interest rates. However, with core inflation expected to keep rates higher for longer, US corporate borrowers and their debt may begin to face more problems than they expected.