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The spread between corporate and U.S. bond yields has narrowed to its lowest level in nearly 20 years as investors bet on a “soft landing” for the world’s largest economy.
The spread that investment-grade companies pay to the U.S. government – the additional cost of borrowing – fell to just 0.83 percentage points this week, the smallest difference since March 2005.
Spreads for borrowers in the high-yield or “junk” rated bond market are now just 2.89 percentage points, the lowest level since mid-2007, according to ICE BofA data.
The narrowing of the spread, which represents default risk, reflects investors’ belief that the U.S. Federal Reserve will succeed in controlling inflation without triggering a recession in which some companies struggle to service their debts.
But some fund managers worry that the $11 trillion U.S. corporate bond market is becoming too complacent about lingering economic risks and the potential for disruption after November’s presidential election.
“Broadly speaking, the market is completely pricing in a soft landing,” said Mike Scott, head of global high yield at asset manager Man Group.
Prices for corporate and government bonds, which move inversely to borrowing costs, have been rising on expectations of further rate cuts after the Federal Reserve cut interest rates for the first time since 2020 last month.
The resilience of the economy has increased demand, especially for corporate bonds, which are riskier than U.S. Treasuries.
Demand for corporate bonds is outpacing new supply, said Bill Zox, portfolio manager at Brandywine Global Investment Management. “We are seeing huge demand for everything credit-related,” he added.
The market has rebounded from a decline in August following weaker-than-expected U.S. employment data.
But TCW portfolio manager Ruben Hovhannisyan said the episode “shows how overbought the market is” and “how little, if any, margin for error there is.” Ta.
He added: “These are people who are just buying bonds believing that everything is rosy and great… You might be surprised.”
Spreads on U.S. Treasuries have narrowed to multi-decade lows, but the total cost of borrowing for companies remains above the 15-year average of near-zero interest rates after the financial crisis.
The average yield on junk bonds, which is inversely proportional to price, is 7.29%, up from less than 5% three years ago.
Some fund managers have warned that buyers are so focused on improving overall yields that they are ignoring the razor-thin protection against increased defaults offered by current spread levels.
Loren Wagant, a portfolio manager at T. Rowe Price, said the bond market of all types has been flooded with yield-based buyers. But he cautioned that valuations are high and said, “You need to have dry powder in case you hit that volatility.”
