What are credit spreads and why should I care?
A credit spread is the difference between the interest rate on a risk-free bond (such as a US Treasury bond) and a bond with risk, such as one issued by a corporation. Larger credit spreads imply that there is more risk that an investor might not get repaid. This can happen for a variety of reasons and might be limited to a corporation’s own particular difficulties, or trouble with the economy as a whole.
If we look at the credit spread of an index comprised of hundreds of companies drawn from a wide variety of industries, we can remove much of the company specific risk, and thereby draw conclusions about what’s happening in the economy in general.
In the chart below, the blue line represents an index that tracks credit spreads for a broad group of companies since the 1990’s. The grey shaded areas are recessions. The red line is the value of the NASDAQ composite stock index.
Notice how the blue line rises before each grey shaded area appears. That’s the phenomenon of credit spreads predicting recessions. Also notice how every major drop in the red line of the NASDAQ is either preceded or accompanied by a rise in the blue line of credit spreads. Credit spreads clearly have a pretty good track record of predicting both recessions as well as trouble in stock prices.
So why does this matter now? Let’s zoom in on that chart and show the past year (apologies for the small gaps on the chart, it appears to be a charting artifact from the data source, The Federal Reserve Economic Data -FRED).
After falling in early 2021, credit spreads hit a low just above 3.0% before rising to 3.4% in July, 3.6% in December and nearly 3.8% the week of Valentine’s Day. While we’re a long way away from the giant credit spreads seen in past recessions, this series of increasingly larger credit spreads is worth taking note of. It is the bond market’s way of saying that some economic weakness, some stock market weakness and perhaps even a recession may be headed our way in the not-too-distant future.
So why I should care about all this? Honestly, YOU probably shouldn’t need to. It is just an example of the kind of market insight that you can develop after many years. At VMI, our core investment strategy has been in use for over 30 years. Give us a call or set up an appointment using the link below to learn more about it, as well as the many other aspects of financial planning that we provide.
Jim, Mark and Dave
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