A 'Yellow Light' From the Bond Market

By Brett Eversole

Bonds are the simplest form of investing...

You lend money to a company. Then, over time, you expect to get it back – plus interest.

You don't have to worry about the company's long-term prospects. It doesn't matter whether it's dominating its industry... or growing at breakneck speed.

You really only need to care about one thing – whether the company can pay you back.

As that risk goes up, bondholders charge higher interest. And that creates an important dynamic in the bond markets... the difference between what bondholders charge for risky bonds versus safe ones.

Today, that spread is the smallest it has been in more than a decade. That's a serious "yellow light" for the market. And eventually, it will end badly. But as I'll share today, that doesn't mean it'll end soon.

Let me explain...

Again, bond investing doesn't come with the same worries as stock investing. For bonds, sentiment comes down to just one concern – whether a company can return your investment.

This also means that bond sentiment helps us understand what folks expect for the economy... because defaults tend to cluster when economic times are tough. So, to see how bond investors feel, we want to look at interest-rate spreads.

Specifically, we use the ICE Bank of America U.S. High Yield Index Option-Adjusted Spread. That's a mouthful – but it simply shows the difference between the yields on high-yield bonds and risk-free U.S. Treasury bonds.

This spread shows how much more money investors are asking for in exchange for the risk of high-yield bonds. When the spread is low, it's a "yellow light" of sorts.

Low high-yield spreads tell us bond investors aren't too worried about the future... And we know bad times usually happen when no one expects them.

Right now, the high-yield spread is the lowest it has been since 2007. Take a look...

The spread has been falling since the middle of 2022. It was roughly 6 percentage points back then. Today, it comes in at just 2.6 percentage points.

That reading is also lower than anything we've seen this decade... or in the 2010s. Heck, the last time we saw a spread this narrow was the middle of 2007.

That date might make you nervous. As you can see above, the last time the high-yield spread hit these levels was just before the worst economic period – and worst stock market collapse – of our lifetimes.

The extreme low didn't last long back then. Spreads quickly soared. The economy tanked... And investors across the board took a beating.

Are we setting up for a similar situation now?

I don't think so. That's because the chart above also shows that spreads tend to fall, and then stay low, for years.

In the 2000s, the high-yield spread declined and then stayed low for four and a half years before that 2007 spike. It was similar in the 2010s... with more than a decade of mostly falling and low spreads before the pandemic-induced recession.

In other words, low spreads aren't the real worry. The "red light" for investors is when spreads rise quickly. When spreads begin to soar, something bad is happening in the economy. And that means pain is likely on the way for investors.

We're not there yet. Spreads are low and still falling. That won't last forever. But history says it could still be years before this low spread goes from a yellow light to a red light.

Good investing,

Brett Eversole

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