Corporate spreads should be the yield compensation for the risk taken with holding a debt instrument. The spread should pay investors for taking a certain probability of default over the life of the bond as well as the liquidity premium relative to a comparable risk free asset. If defaults or the probability of firm failure increases, there should be an increase in spread compensation.
Default rates are rising, albeit during a pandemic, yet spread levels for investment grade and high yield have continued to move lower. Investor may be looking through the pandemic to better times and there is the continued reach for yield. Still, low spreads, the threat of inflation, higher company leverage, and an increase in selected defaults make for a less attractive credit environment.
Defaults have been centered with the lowest quality firms and within specific industries like energy and consumer goods; however, credit markets are more susceptible to any credit surprises when spreads are lower. Equity prices, the residual value of the firm, have continued to move higher so there is no signal of credit weakness, but investors should still focus on credit as a potential risk flashpoint - limited excess return for potentially increasing risk.
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