With perceptions of heighted geopolitical risk along with weakening economic results, uncertainty continues to persist and prevail across markets. The Trump administration continues to vacillate between will-he or won’t he tariff speculations, almost daily changing policy pronouncements, and growing angst over a potential government shutdown (March 14th) appear to be wearing investor nerves thin and stirring the demand for defensive assets.
Nonetheless, U.S. Investment Grade Credit spreads have recently been trading at historically tight spreads (i.e., the additional compensation for taking on the additional risks over the risk-free rate). Credit conditions for corporate borrowers appear to be favorable.
Investment Grade Credit Spreads
However, the prospect of materially higher tariffs could reignite inflation and force the Federal Reserve to halt—or possibly reverse—its dovish interest rate cycle of monetary-policy easing. Higher interest rates can hurt credit, and so can a weaking economy. Both situations can negatively affect corporate earnings and therefore impact a borrower’s ability and willingness to pay back debt in a timely manner.
The cost to borrowing could become burdensome (i.e., facing challenges to service or refinancing debt), if the Fed has to recalibrate and raise interest rates. Investors could also grow weary and demand higher risk premiums amid slowing economic growth. These oppose market forces, raise policy uncertainty, which adds to the specter of market volatility.
Credit Default Swaps (CDS) are often used to gage whether something has gone wrong in the markets. These derivatives are similar to an insurance policy that pay out if a company defaults on its debt. The Markit CDX North American Investment Grade Index, a broad swap basket of various industries, also seems tranquil as it hovers at 50.28, near its low of 45.27.
Investment Grade Credit Default Swaps Rates
So…is this a Red Flag? With investment grade credit spreads at or near their tightest (i.e., lowest levels) in two decades, is the market misdiagnosing the situation? Are fixed income investors being compensated enough to take on additional credit risk?
Well, only time will tell. For now, these investors believe the compensation outweighs the risks. But these low spreads are something to keep one’s eye on, and perhaps they are an indication of potential problems to come.
Source: Bloomberg LP. Content should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Material presented is believed to be from reliable sources, however, we make no representations as to its accuracy or completeness. This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product.
