Cracks Showing in the Corporate Credit Markets

Lawrence Gillum (00:00):

With U.S. equities officially entering correction territory last week and the VIX Fear Gauge spiking, investor uncertainty has reached levels we haven't seen in quite some time. The turbulence in equity markets driven by tariff concerns, slowing economic indicators and questions about the sustainability of AI investments has naturally raised questions about what's happening in the corporate credit markets. So, in this edition of the LPL Street View, we take a look at the corporate credit markets to see what, if any, signals are sending about the broader economy. The last few weeks have been all about equity market volatility, and my colleagues on the equity side have been doing yeoman's work, providing resources so our LPL advisors have the resources they need for these important conversations that they're having with their clients. So today I wanted to complement their work and provide an update on what we're seeing in the corporate credit markets, particularly as it relates to credit spreads.

Lawrence Gillum (00:49):

Credit spreads are critical indicators that deserve our attention for several key reasons. First, they serve as the market's real time assessment of corporate credit risk. When spreads widen, it signals that investors are demanding greater compensation for taking on risk, reflecting concerns about future default rates or economic conditions. Second, credit markets often prove to be leading indicators for the broader economy. Historically, significant spread widening has preceded economic downturns as credit investors tend to be among the first to identify and price in deteriorating conditions. Finally, widening spreads directly impact funding costs for corporations. As borrowing costs become more expensive, companies may delay capital investments, reduce hiring or postpone expansion plans, which can ultimately feed into broader economic slowdown. After trading at or near secular tights for quite some time, we're finally seeing spreads widen a bit. High yield is now at 3.21%, which is about 60 basis points higher than the February lows.

Lawrence Gillum (01:49):

The CCC rated segment, which represents companies most at risk of default, has moved even more dramatically, nearly a hundred basis points above recent lows. Not even investment grade has been immune with spreads widening about 17 basis points over the past few weeks. Now, this is happening alongside the broader market correction we've seen in the equities, which officially hit the 10% mark last week for the first time in nearly 350 trading days. The uncertainty around tariffs, some deceleration in consumer spending and employment data and questions about AI spending have contributed to this risk off rotation. But the broader question remains, are widening credit spread signaling there could be deeper risks on the horizon? At this point the data doesn't support that conclusion. While spreads are widening, they're doing so from historically tight levels and the magnitude simply doesn't match what we typically see heading into economic contractions.

Lawrence Gillum (02:39):

During genuine pre-recession periods, we'd expect to see high yield spreads widen much more dramatically, often by 450 basis points for garden variety recessions or up to 1200 basis points for more severe concerns compared to our current 60 basis point move wider. Remember that credit markets are forward looking, and right now they're suggesting increased caution, but not sounding alarm bells. We're seeing a period of higher volatility, not necessarily the beginning of a severe downturn. However, and this is the key point, while spreads have widened, they're still quite tight by historical standards. High yield spreads are only in the 17th percentile since 2002, meaning they've been wider about 83% of the time, and that's what grade is similar sitting in just the 18th percentile. So what we're seeing, we believe, is a realignment to a more normal environment after an extended period of exceptionally tight spreads. This isn't pushing towards recession levels.

Lawrence Gillum (03:32):

We're not even back to where we were last summer when a temporary growth scare pushed spreads wider. The bottom line is that yes, credit spreads are widening, but they're only returning to a more normal environment after trading at or near secular tights for quite a while. This appears to be a healthy recalibration rather than a signal of more serious economic deterioration. For now, though, we recommend caution with the economic outlook cloudy at best, we remain underweight investment grade corporate credit, and neutral on high yield. We will continue to monitor tariff news, economic data, earnings estimates, and various technical indicators to identify if and when market conditions improve. And while the risk reward tradeoff for investing has clearly improved, a swift and sustainable recovery seems unlikely under the cloud of trade uncertainty. That's it for now, but for more information on global capital markets, make sure you're following us on our social media accounts. Take care.