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Why Rising Credit Spreads Point to a Slowing Economy

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Credit Spreads

Both high yield and investment grade spreads have been widening, with high yield spreads recently hitting multi-year highs. While spreads are a less reliable indicator than those above, wider spreads indicate rising default risk, which is normally associated with a recession or sharp slowdown.

Increasing Credit Spreads Point to a Slowing Economy

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Market Realist – Increasing credit spreads point to a slowing economy.

The graph above shows the spread between the yield on US high yield bonds (HYG)(SJNK), as tracked by the BofA Merrill Lynch US High Yield Master effective yield, and the 10-year Treasury (IEF). The difference between the yields on corporate bonds and Treasury bonds of the same maturities is often known as the “credit spread.” This is because Treasuries don’t involve credit risk while corporate bonds do.

Usually, when the economy is improving, credit spreads contract. This is because credit markets are usually improving when the economy is, and the possibility of a default on corporate bonds (LQD) reduces, causing yields to fall. Meanwhile, as the economy improves, Treasury yields rise as investors move to riskier assets. This causes the credit spread to contract.

The opposite happens when the economy is in a downturn. Investors turn to Treasuries and other safe assets, dumping risky assets like high-yield bonds, which now have heightened default risks, and causing their yields to rise and credit spreads to expand.

As you can see in the graph above, the credit spread has been climbing since June 2014. It now stands at 570 basis points compared to a little above 250 basis points at its low last year. This suggests that the economy is slowing.

However, one of the reasons for expanding credit spreads is that energy companies (XLE) now make up ~15% of the total US high yield bond market. Lower oil prices have hammered energy companies’ earnings, increasing their default probabilities.

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