Credit spreads: high yield vs investment grade

If you could watch only one intermarket series, many experienced traders would choose credit spreads. Corporate bond investors are paid to worry about default, they are large and slow-moving, and they tend to notice stress before the equity market prices it. Credit spreads are their worry, expressed in basis points.

What a spread is

A credit spread is the extra yield a corporate bond pays over a government bond of similar maturity. It compensates for default risk and illiquidity. The standard measure is the option-adjusted spread (OAS) of a bond index, published daily.

Investment grade is rated BBB- or better; high yield ("junk") is below that. HY spreads are more volatile and more sensitive to the economic cycle because HY issuers are closer to default. HY is the series most traders watch.

The levels above drift with the cycle and with the composition of the indexes; treat them as orientation. As with everything in this course, the rate of change is more informative than the level.

Why credit leads

A stock is a claim on whatever is left after debt is paid. A bond is a claim on the debt. When a company's prospects deteriorate, the bond investor's question ("will I get paid?") becomes urgent before the equity investor's question ("how much will I get?") does. Credit analysts also have covenants, cash-flow forecasts and refinancing calendars in front of them that equity screens ignore. And credit is where leverage lives: a company that cannot refinance fails regardless of its share price.

The result is that HY spreads tend to widen before or alongside the start of serious equity declines, and to stop widening before equities bottom. The relationship is not perfect (credit has thrown false alarms during sector-specific stress, notably energy in 2015-16) but it is one of the more reliable intermarket leads.

HY OAS (bp)         Equity index

 300 ──╲                ╱‾‾‾‾╲            spreads widen while stocks still rise
 400    ╲___╱‾╲        ╱      ╲
 500        ╲__╱╲     ╱        ╲__
 600             ╲___╱            ╲___
 700                 ‾‾╲___       ╱‾‾    spreads stop widening; stocks bottom later
                                 ╱

Key idea: Credit investors worry about default before equity investors worry about valuation. Widening high-yield spreads while stocks rise is a warning; spreads that stop widening while stocks fall is an early sign of a low.

How to read them

Direction over 20 days. HY OAS wider by more than 50 bp in a month with the index near highs is a divergence worth logging. Wider by more than 100 bp is a serious one.

HY vs IG together. If both widen proportionally, it is a broad risk repricing. If HY widens while IG is calm, the stress is concentrated in weak balance sheets, which can be sector-specific. If IG widens sharply, something systemic is happening; IG rarely moves without a real problem.

ETF ratios for intraday. OAS data updates once a day. For a faster read, the ratio of a high-yield bond ETF to an investment-grade or Treasury ETF gives a market-hours view. Rising means risk appetite in credit; falling means risk aversion. The ratio is noisier than OAS but it is live.

Credit in the regime sentence

Credit gets one word in the morning sentence: calm, widening, stressed or tightening. It is the slowest-moving line in the sentence and the one you least want to be surprised by.

Combined with the tools from earlier modules:

• Breadth narrowing + VIX in contango + credit calm: a late-cycle rally that is still being funded. Trade it, with size awareness.
• Breadth narrowing + VIX flipping to backwardation + credit widening: the funding is leaving. Tighten, reduce, hedge.
• Breadth washed out + VIX steep backwardation + credit spreads stop widening: the ingredients of a low, waiting for price.

Failure modes

• Reading absolute levels across eras. 400 bp was wide in 2019 and tight in 2009. Use rate of change and percentiles.
• Ignoring composition. The energy share of the HY index rose sharply in the 2010s; the 2015-16 widening was mostly that. Know what is in the index.
• Expecting credit to time equity lows. It leads, sometimes by weeks, sometimes by months, and it can stop widening while equities fall a further 15%.
• Using ETF ratios without OAS. ETF prices carry rate risk and flows; the OAS strips the rate component out. Use ETFs for speed and OAS for truth.

Try it: Pull the HY OAS series for the past ten years (it is free from the St. Louis Fed's data site) and overlay the S&P 500. Mark every month where HY OAS widened by more than 100 bp. For each, note the index's peak-to-trough drawdown in the following three months. Then mark every month where OAS narrowed by more than 100 bp from a level above 600 and note the index's return over the next six months. You now have the two halves of the credit-leads-equity claim, tested on your own data.

Recap

• A credit spread is the yield premium over government bonds; the high-yield OAS is the series most traders watch, with IG as the systemic check.
• Credit tends to lead equities because bond investors face the default question first and see the refinancing calendar.
• Read spreads by 20-day change and by the relationship between HY and IG; use ETF ratios for a live read and OAS for the daily truth.
• Widening with stocks at highs is a warning; spreads that stop widening during a selloff are an early ingredient of a low.
• Levels drift with the cycle and index composition; use rate of change and percentiles.