A prolonged period of unusually low junk bond spreads could be setting the stage for a dramatic market reversal, according to this economist, who sees eerie similarities to the pre-crisis conditions of May 2007.
What Happened: The credit spreads of high-yield or junk corporate bonds have remained below 3% for over 100 days, highlights the macro strategist at Crescat Capital, Otavio Costa in an X post.
According to Costa, a trend like this was observed in May 2007 which followed a spike in volatility and shattered market complacency, triggering a sharp widening of spreads. He draws a parallel between this incident to the current situation.
“Tight credit spreads are like tinder — just waiting to catch fire,” Costa added.
Why It Matters: A junk or a high-yield corporate bond is a debt instrument that has a below-investment-grade credit rating, whereas a credit spread is the difference between the yield on the junk bond and the yield on a comparable U.S. Treasury bond. The spread represents the extra return of the high-yield bond above the Treasury bond.
A lower credit spread indicates that a bond is considerably safer and investors are more confident in the ability of a company to repay its debts. A prolonged period of lower spreads could signal excessive risk-taking by investors, as they may become complacent about potential risks.
The graph shared by Costa highlights Bloomberg U.S. Corporate High Yield Average Options-Adjusted Spreads, which have been below 3% for 100 straight days. According to him, this is a warning signal of upcoming volatility.
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