SOMETHING is strange about recent bond-market action: Rising borrowing costs aren’t putting upward pressure on average default risk. What explains that?
The yield on the benchmark 10-year US Treasury bond has jumped from a 2026 low of 3.96% in February to a 24-year high of 5.31% on Oct 5.
Let’s logically think through the implications for corporate bondholders.
Higher interest rates mean corporations’ borrowing costs will rise. At the same time, higher rates should slow the economy, depressing corporate earnings.
The combination of higher interest expense and lower earnings should seemingly increase the risk of companies failing to generate enough cash to make their required coupon payments – in other words, defaulting.
If default risk has increased over the past seven months, surely the corporate bond spread – the additional compensation investors demand for default risk – must have risen as well.
But here’s the odd thing. ICE Indices reports the exact opposite. Between February and September, the spread on its US investment grade corporate bond index declined from 86 basis points to 84.
If this outcome strikes you as anomalous, you’re not alone.
When I began my career in the bond market, old hands taught me that the corporate yield spread is proportional to Treasury yields. That is, the higher the yield on Treasuries, the greater the spread.
Many years later, a distinguished finance professor sat in my office and insisted that any other relationship between Treasury yields and corporate spreads was an obvious impossibility.
In the intervening years, though, a smart colleague wised me up.
He suggested that the Treasury yield and the United States investment grade corporate spread are inversely correlated, meaning that the higher the Treasury yield, the smaller the corporate spread.
Driving home the point, the narrowest spread, 54 basis points, occurred in September 1997, when the Treasury yield was at 6.12%, near the high end of its range.
By contrast, the yield was only around the middle of its range, at 2.96%, when the spread reached its maximum of 608 basis points in November 2008.
Similar trends are found in the high-yield bond market as a whole, though bonds in the lowest credit ratings segment – CCC and below – have seen their spreads widen as borrowing costs have risen.
While rate and spread dynamics can be complicated, numerous academic studies have confirmed that spreads usually narrow as yields rise, contrary to the logical-sounding argument otherwise.
This perhaps counter-intuitive trend is explained by another logical line of reasoning. High Treasury yields can arise from two key sources, both of which strengthen rather than weaken corporations’ credit quality.
First, interest rates can rise because a vibrant economy creates high demand for debt capital to finance corporate investments in attractive business opportunities.
A thriving economy should boost the earnings that enable companies to make those required interest payments.
On the flip side, if the economy is weakening or if there is a market panic, credit spreads can widen even as the Federal Reserve is lowering its policy rate to boost the economy or stabilise the financial system.
Indeed, that is precisely what was happening in November 2008. Next, interest rates can go up because investors’ expectations for future inflation are rising. That can also be good for borrowers.
Why? Because if inflation turns out to be higher than the market expected when the firms issued their bonds, they will get to repay the borrowed money in cheaper dollars.
Inflation can have other negative impacts on corporate profitability, of course, but, as a rule, inflation benefits borrowers.
Marty Fridson is the publisher of Income Securities Investor. The views expressed here are the writer’s own.
