Corporate credit markets have reached an extreme level of complacency; spreads have narrowed to levels not seen since 2007 just before the global financial crisis and in some cases, they are as tight as they were in 1998 before the Asian financial crisis. Despite this, Wall Street is not unaware of the risk; rather, market participants fully recognize that credit spreads are historically mispriced and that the risks they are accepting are not being adequately compensated. The prevailing mentality is not one of ignorance but of waiting; the entire market understands that it is holding onto a fragile situation, effectively grasping a tiger by its ears, only willing to let go when specific conditions emerge to justify a rapid unwinding.
This is what happened in August of last year; it was not so much that a sudden trigger collapsed the carry trade but rather that fears of such a signal emerging led to a sharp repricing. Now, in early 2025, those same conditions appear to be forming again, with a resurgence in ultra-low spreads coinciding with data that suggests economic momentum is rapidly fading. The U.S. economy, after a minor boost at the end of last year, is now showing signs of rolling over, and if that continues, then these compressed credit spreads may indeed be a tinderbox ready to ignite.
Historically, extreme levels of complacency have never been a positive sign. While they are not timing signals in and of themselves, they indicate that risk is being severely mispriced. The last time credit spreads were this tight was June and July 2007, right before the financial crisis began; before that, in 1998, spreads reached similar levels just prior to the Asian crisis. Looking at Triple B-rated spreads, which represent a middle-tier risk within corporate credit, they have now fallen below 100 basis points; levels last seen in 1998. Bank of America Merrill Lynch’s Master 2 Index, which tracks a broader set of corporate credit spreads, has fallen to around 260 basis points, the lowest level since 2007.
Credit spreads represent the additional yield demanded by the market over and above comparable U.S. Treasury bonds. In theory, riskier debt should offer a higher return; the more risk perceived in a debt instrument, the greater the return an investor should demand. Yet for the past several years, spreads have been compressing, offering increasingly lower risk premiums despite worsening economic conditions. This divergence has reached a level where even Wall Street analysts are beginning to sound the alarm. Bloomberg recently reported that corporate bond price movements have become so stable that some money managers are questioning whether the relentless rally in credit is itself a red flag. Franklin Templeton Investment Management and AXA Investment Managers have already begun reducing exposure to corporate bonds in favor of government securities and cash, citing the inadequate return relative to risk.
Despite these warnings, capital continues to flow into corporate bond funds, and systemic traders remain highly leveraged in corporate credit. This is not because investors believe risk has disappeared but because they do not know when market conditions will shift. The complacency stems from the belief that the lack of immediate danger means there is no need to act preemptively. David Zahn, Head of European Fixed Income at Franklin Templeton, pointed out that the risk of a policy mistake across multiple jurisdictions remains high. What he is really saying is that central banks have held interest rates at restrictive levels for too long, increasing the likelihood of an economic downturn. While many interpret this as a warning of monetary policy missteps, the reality is that economic weakness has long preceded the Fed’s rate hikes; the economy that “forgot how to grow” has been deteriorating for years.
Recent economic data further supports this thesis. The downturn in Europe is accelerating, and momentum in the U.S. is fading. Australia, once considered among the strongest economies, has now resorted to cutting interest rates, further underscoring the global slowdown. Zahn’s total return fund has already reduced its exposure to credit from over 40% last summer to just under 25%, shifting to safer government bonds. The corporate credit market’s volatility has nearly disappeared; spreads have remained unnaturally tight for an extended period, reinforcing the idea that the market is underpricing risk. However, history suggests that such stability is illusory and that once a shift begins, the correction will be rapid and severe.
In 2022, credit spreads widened sharply for two reasons: (1) the economy showed signs of instability, and (2) the prospect of higher interest rates raised concerns about corporate solvency. As central banks continued to raise rates aggressively, corporate bond investors feared that weaker companies would struggle to survive in a high-interest-rate environment. This led to substantial selling in risky corporate credit, driving spreads higher. However, by late 2022, the bond market stabilized, with interest rates plateauing. The corporate credit market interpreted this as a sign that central banks had reached their peak in tightening and that financial conditions would not worsen further. This perception fueled a rally in corporate credit and a continued compression in spreads, despite worsening economic conditions.
At the same time, corporate credit markets mirrored the stock market; both were waiting for specific recession signals to confirm the need to sell. The conventional indicators, negative GDP growth, rising unemployment, and a sharp deterioration in payrolls, never materialized in the traditional way. This allowed complacency to persist. Instead of recognizing the broader economic deterioration, market participants continued to rationalize tight spreads, believing that as long as headline data did not confirm a recession, risk assets could continue to perform well. This self-reinforcing cycle has driven spreads lower than at any point in nearly two decades.
In the summer of 2024, these assumptions were briefly challenged. The carry trade blowup in August was not an isolated event; it was a symptom of deeper concerns about the labor market. Japanese investors, who had been heavily invested in similar structured credit products, became nervous as U.S. labor market data weakened. The fear was that if job losses accelerated, the long-awaited recession signals would emerge, triggering a mass sell off in corporate credit. This led to a spike in spreads, widespread deleveraging, and a downturn in equities. While markets recovered, the underlying risks never disappeared; the structural weaknesses in the economy remain, and the same triggers that spooked investors last summer are resurfacing now.
The issue with credit spreads is that they reflect perceptions of risk rather than objective economic conditions. When spreads are at extreme lows, they signal that the market is severely underpricing risk. However, they do not provide a reliable timing signal; spreads will remain tight until a recognizable trigger emerges. The problem is that by the time those signals appear—such as negative GDP growth or substantial job losses—the reaction is already underway. This is what happened last August; the sell-off began not because of actual economic collapse but because investors feared that such a collapse was imminent.
As the economy continues to weaken, the likelihood of those triggers appearing increases. Consumer confidence has rolled over sharply, labor market data continues to erode, and retail sales have disappointed. The same conditions that led to the credit spread blowout last summer are re-emerging. Despite this, credit spreads remain dangerously compressed, reinforcing the market’s fragile equilibrium. When the inevitable shift occurs, the unwinding will be swift and indiscriminate; investors know this but remain trapped, unwilling to exit their positions without a clear signal.
The most dangerous aspect of today’s market is not the level of interest rates or central bank policy; it is the extreme level of complacency.
The last time markets were this indifferent to risk, they were on the precipice of collapse. The economy has not recovered, and now conditions are aligning for the next stage of deterioration. Investors may believe they have time, but the reality is that when the shift comes, it will come quickly; history has already provided the blueprint.
No comments:
Post a Comment