Valuation tension in resilient credit

Credit markets remain supported by strong fundamentals and healthy demand, but tight spreads and rich valuations limit upside, prompting a cautious stance on credit exposure amid signs of softening in earnings and consumer health.

Structural changes in the lending landscape post-the Global Financial Crisis (GFC) significantly reshaped the high yield (HY) bond market, particularly influencing HY credit quality composition. The rise of leveraged loans and private credit introduced new avenues for debt financing as well as new competition, resulting in favorable terms for lower quality borrowers. This dynamic has contributed to elevated overall credit quality within the high yield index. The influx of fallen angels during the COVID crisis further reinforced this trend, as investment-grade (IG) bonds were downgraded into the high yield universe. Collectively, these developments contributed to structurally tighter spreads across credit markets.

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Where we stand on credit markets

High yield and investment grade (IG) credit have outperformed Treasuries YTD as spreads tightened significantly after initially widening post liberation day. However, with spreads at historically tight levels, we are conservative on credit exposure, reflecting a tug of war between valuations and fundamentals. Valuations are a key reason behind our conservative stance on credit. The Bloomberg US Corporate HY index option-adjusted spread (OAS) currently sits at 278bps while US Corporate IG spreads are 76bps. This is tighter than 96% and 99% of daily spreads, respectively, over the last 20 years. In short, valuations are on the very rich side of fair value, leaving little room for further appreciation from spread compression.

From a fundamental perspective, corporate balance sheets and earnings overall remain healthy for both IG and HY issuers. However, we are starting to see some softening in this data. IG earnings growth hasslowed, although notably it has avoided outright contraction, while margins and debt service capacity have showed some deterioration (figure 1). We continue to watch for softening in the labor market andhave noted a recent increase in consumer delinquencies.

High yield is a broadly similar story to IG: fundamentals continue to look healthy. Leverage ratios are well off their pandemic-era peaks, and interest coverage remains solid. Distress ratios and default rates tend to be good indicators of the overall health of issuers in the index. The latest data from BofA shows the HY index distress ratio (% of bonds trading at a spread of 1000+bps) is at 5.7% (figure 2), which is well below the 20Y average of 10.6%. Similarly, default rates remain near historic lows. This suggests there’s little stress in the HY market.

From a market technicals perspective, both supply and demand for US corporate credit are robust across the board. The primary market has come roaring back in HY with almost $100bn in new issuance in Q2, and IG issuance is already outpacing 2024’s total of almost $1.5 trillion. Despite the spread compression discussed previously, higher yields across the Treasury curve have kept all-in yields on US corporate bonds attractive. As a result demand remains healthy from pensions, insurance, retail, and overseas investors searching for yield.

The result of this tug of war is a delicate balance between relatively stable fundaments and strong technicals on one side and valuation on the other. An aggressive underweight would result in under-yielding the index over an extended period, while an overweight brings the risk of significant price weakness should conditions worsen materially. In our view, credit markets present asymmetric risk to the downside. At current valuations, the potential for price appreciation through further spread compression is limited, while the incremental compensation over Treasuries is not sufficient to offset the credit risk taken. We remain conservative on credit risk today.