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With US corporate credit spreads at their tightest levels in 19 years, investors are at a crucial juncture.

This calls for a renewed focus on valuations.

The US corporate credit market has experienced a remarkable recovery since the pandemic-induced volatility of 2020. Spreads across investment-grade and high-yield bonds have compressed significantly, driven by accommodative monetary policies, fiscal stimulus, and improving economic conditions.1,2

As we hit new option-adjusted spread (OAS) tights + 79 on October 17 – investment-grade corporate bonds are particularly affected (Chart 1).3

Chart 1. High yields + Weak spreads = Quite a conundrum

While some argue that the current index’s shorter duration and lower dollar price compared to previous periods could support even tighter spreads, we believe this compression still warrants careful consideration.4 Even amid increasing macro and geopolitical risks, this movement in credit spreads emphasizes the importance of thorough valuation analysis.

We believe investors must carefully consider whether the fundamentals justify this rally or if it represents a potential mispricing of risk that could lead to future market corrections. Thus, it underscores the need for caution and alertness, keeping investors vigilant and proactive.

Why valuations matter

Valuations serve as a compass for credit investors, providing crucial insights into the risk-reward profile of fixed income securities. We believe they are essential in the current environment for several reasons.

  • Valuations act as an indicator of market sentiment.
    Tight spreads often reflect optimistic market sentiment and a strong risk appetite among investors. However, this optimism can sometimes outpace fundamentals, leading to potential mispricing of risk. Understanding this guidance from valuations can reassure investors in their decision-making process.
  • Valuations are forward-looking measures.
    They incorporate expectations about future economic conditions, corporate performance, and default probabilities. As such, they offer a glimpse into the market’s collective wisdom about what lies ahead.
  • Relative value becomes increasingly important in a low-yield environment.
    Valuations help investors compare opportunities across sectors, credit qualities, and maturities to optimize portfolio allocation. We believe this strategic use of valuations can make investors feel resourceful in navigating the low-yield environment.
  • Valuations serve as a risk management tool.
    By assessing whether securities are fairly valued, overvalued, or undervalued, investors can better manage downside risk and identify potential opportunities for alpha generation.

The importance of historical context

As we approach three-year tights in the corporate index, we believe investors should consider how current spreads compare to 5-year, 10-year, and longer-term averages. This context can help identify potential mean reversion opportunities or risks.

How did we get here?

The start of the US Federal Reserve (Fed) cutting cycle sets up a risk-on backdrop for risk assets, signaling the Fed's view that inflation concerns are under control, yet policy is currently too restrictive. While growth has slowed, we are still in a comfortable range, and company fundamentals tell a similar story. Technicals remain a driving force, with corporate bond yields for investment grade still at levels we could not touch for a decade (2010–2021) as strong inflows continue from multiple sources (retail, insurance, pension, foreign).

Where do we go from here?

While the outlook for total returns remains favorable in investment grade, the compression across ratings and capital structures – now pushing through to 19-year tights – leads us to believe investors must look to add quality to their portfolio.

We believe investors must hold a cautious stance even accounting for the current index’s shorter duration and lower dollar price relative to historical periods, which could theoretically support tighter spreads. We recommend focusing on downside protection by reducing exposures to subordinate issues, low BBBs, and cyclicals in favor of higher quality senior, less cyclical, A-rated issuers.

Final thoughts

As US corporate credit spreads reach levels not seen since 2005, the importance of rigorous valuation analysis cannot be overstated. While tight spreads reflect positive economic sentiment and strong corporate fundamentals, they also signal reduced compensation for risk. Though structural changes in the index might suggest room for further tightening, we believe the current environment calls for increased vigilance and a strategic shift toward higher quality assets.

1 Spread refers to the difference between the bid (buyer's price) and the offer (seller's price) of a security or asset.
2 Companies whose bonds are rated as 'investment grade' have a lower chance of defaulting on their debt than those rated as 'non-investment grade'. Generally, these bonds are issued by long-established companies with strong balance sheets. Bonds rated BBB or above are known as Investment Grade Bonds.
3 The option-adjusted spread (OAS) is a calculation of the relative value of a fixed income security containing an embedded option, such as a borrower’s option to prepay a loan. A larger OAS implies a greater return for greater risks.
4 Duration is a measure of the maturity of a bond or portfolio of bonds that takes into account the periodic coupon payments. It attempts to measure market risk, or volatility, in a bond by considering maturity and the time pattern of interest payments prior to repayment. Two bonds with the same term to maturity but different coupon rates will respond differently to changes in interest rates. So will bonds with the same coupon rate but different terms to maturity. The higher the duration, the greater a bond’s price-sensitivity to changes in yield.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

AA-301024-185170-1

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