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Early signs of stress are emerging in the high-yield bond market as investors increasingly demand greater compensation for holding the riskiest corporate debt. While this does not signal a full retreat from high-yield bonds, market participants are advised to monitor evolving conditions closely.
The yield on high-yield bonds has risen to 8.1%, up from 7.22% one month ago. This uptick reflects broader yield increases across fixed-income markets, driven by investor expectations of sustained inflation amid elevated energy prices and growing concerns about fiscal deficits, which reached nearly $2 trillion in the fiscal year ending September 30.
The high-yield market is also experiencing pressure on the credit front. According to the Federal Reserve Bank of St. Louis, credit spreads — the gap between corporate bond yields and comparable Treasury securities — have widened to levels last observed in April. Expanding spreads indicate that investors perceive greater risk in corporate debt, requiring higher returns for holding such positions.
Currently, the average spread in the high-yield market stands at 315 basis points — up from the previous year but still below the 346 basis points recorded in March. One basis point equals 0.01%.
The high-yield universe includes bonds rated BB+ by S&P and Fitch, and Ba1 or lower by Moody’s. Among these, the lower-tier segment rated CCC and below has experienced the sharpest increase in spreads, climbing to approximately 1,250 basis points over the past year.
A Cautious Signal: Not Red Yet
The current state of the high-yield market can be described as “flashing yellow,” signaling caution rather than alarm, according to Michael Arone, chief investment strategist at State Street Investment Management.
As interest rates climb, it is reasonable for investors to seek higher compensation for assuming additional credit risk, he noted. Across the board, yields remain elevated, with the 10-year Treasury reaching its highest level since 2002 earlier in the week.
“The key question is whether this represents a simple repricing of interest rate risk or marks the beginning of a deeper reevaluation of credit quality,” Arone said.
Despite rising concerns, Arone remains in a wait-and-see stance. Earnings continue to grow, interest coverage ratios remain solid, and although default rates have shown slight increases, they have not yet reached worrisome levels.
Nonetheless, the historically low starting point of spreads continues to weigh on investor sentiment. “There’s a small margin of safety here, which adds to anxiety,” Arone explained. “The compensation investors receive for taking on credit risk is modest compared to historical norms, making even minor shifts in spreads potentially significant.”
Structural Strengths Persist Amid Select Weakness
Though some segments of the lower-rated market face challenges, the overall high-yield landscape remains fundamentally sound.
In fact, credit quality within the high-yield space is at record highs. Kelley Gerrity, a fixed income strategist at Morgan Stanley Investment Management, noted that BB-rated bonds now account for over 60% of the market — up from just 38% before the global financial crisis.
“We’ve seen stronger companies entering the market, and with higher borrowing costs, there’s also greater discipline among highly leveraged firms. This dynamic is contributing to a healthier overall environment,” she observed.
The lowest-rated segment of the high-yield market — CCC and below — has always carried inherently higher default risk, so it is unsurprising that this cohort leads the widening trend in spreads, according to Collin Martin, head of fixed income research and strategy at the Schwab Center for Financial Research.
“The overall movement in high-yield spreads has been orderly. Are cracks forming? Yes — but these are logical ones, primarily affecting the lowest-rated bonds. It’s premature to conclude that this weakness is spreading throughout the credit market,” he said.
Martin added that recent fluctuations within the CCC-rated category have largely been idiosyncratic rather than systemic. Gerrity highlighted that Morgan Stanley recently categorized the lowest tier into two groups: performing assets and non-performing assets, defined by whether their spreads exceed 1,000 basis points.
The non-performing segment currently shows a spread to worst of 2,818 basis points, while the performing bucket — representing the larger portion of the CCC market — trades at 461 basis points.
“This divergence is contained,” Gerrity said. “While it may persist for some time, it does not suggest widespread distress in the credit markets at present.”
Given current dynamics, Gerrity recommends maintaining selectivity within the high-yield space. “We’re targeting areas offering the best relative value, particularly within the single-B cohort, where we believe attractive opportunities exist,” she said.
Monitoring Key Indicators for Broader Market Stress
Investors should remain watchful for any signs of steepening spreads across the broader high-yield market, which could signal deeper systemic issues.
However, there is currently little indication of stress in the BB-rated segment. Spreads there have edged up to 194 basis points from 179 basis points a year ago, though the path has not been uniformly upward.
“Our focus remains on identifying fundamentally sound companies,” Martin said. “If we observe widening spreads in this stronger cohort as well, that would warrant closer scrutiny regarding rising risks.”
R.J. Gallo, chief investment officer of global fixed income at Federated Hermes, emphasized that the Fed’s tightening cycle occurs against the backdrop of a resilient economy. Central bank officials are grappling with persistent inflation fueled by rising fossil fuel prices linked to geopolitical tensions, while economic growth has surpassed expectations.
“Because the rationale behind rate hikes is strong economic growth, we wouldn’t anticipate a dramatic breakdown in high-yield markets. Strong growth supports revenue generation, preserving cash flow and profitability,” Gallo explained.
He cautioned that high-yield assets tend to suffer most during periods of pronounced economic contraction. “That’s typically when spreads expand significantly. However, recessionary conditions are not presently the most likely scenario. If the Fed continues aggressive tightening, or if oil prices remain elevated for an extended period, we may need to reassess our outlook,” he said.