Junk bond warning signs emerge as credit spreads widen

Junk bond warning signs are appearing in credit markets as investors demand more return to own lower-rated corporate debt. For everyday investors, the key issue is whether concern remains concentrated among the weakest borrowers or begins to raise borrowing costs across the corporate market.

CNBC reported that the overall high-yield credit spread recently stood at 315 basis points, above its level a year earlier, though below 346 basis points in March. One basis point is one-hundredth of a percentage point.

What do junk bond warning signs mean?

A credit spread is the difference between the yield on a corporate bond and a Treasury bond with a similar maturity. Because Treasurys are generally treated as lower-risk debt, a wider spread means bond investors want more compensation for the chance that a company could run into financial trouble.

That distinction matters because a bond’s total yield can rise for two different reasons. Treasury yields can increase broadly as interest-rate expectations change. A widening credit spread is a separate move: it reflects greater concern about the company’s ability to repay its debt. CNBC reported that high-yield spreads had widened to levels not seen since April.

Stress is strongest among the weakest borrowers

High-yield, often called junk, bonds are debt rated below investment grade. The most speculative slice, bonds rated CCC and below, has the greatest risk of default. Spreads for that group had climbed to roughly 1,250 basis points over the past year, according to CNBC.

Michael Arone, chief investment strategist at State Street Investment Management, described the market as a caution signal rather than a crisis. He pointed to continued earnings growth and good interest-coverage ratios, which measure how readily a company’s earnings can cover its interest payments. He also said defaults had risen somewhat but were not concerning in his view.

Collin Martin, head of fixed-income research and strategy at the Schwab Center for Financial Research, told CNBC that the wider spreads had been orderly and that it was too early to conclude the weakness was spreading through the broader credit market.

Which credit spreads should investors watch?

• The overall high-yield spread: A fast, sustained increase would show that investors are demanding more compensation from riskier companies more broadly.
• BB-rated bonds: This is the stronger end of the high-yield market. CNBC reported BB spreads at 194 basis points, compared with 179 basis points a year earlier, and said there was scant evidence of stress in the group. Broader widening here would be a more meaningful escalation signal.
• BBB-rated bonds: BBB is the lowest investment-grade rating. A MarketWatch commentary republished by Morningstar argued that widening reaching BBB debt would indicate stress was extending beyond junk bonds. That is commentary, not a forecast.

Market composition offers one counterweight. Kelley Gerrity, a fixed-income strategist at Morgan Stanley Investment Management, told CNBC that BB bonds accounted for more than 60% of the high-yield market, versus 38% before the global financial crisis. Still, spread levels move quickly, and the reported figures do not establish that a recession or broad default cycle is imminent.

This story draws on original reporting from CNBC.