Some excessive yield market individuals declare the times of +1,000-basis-point (bps) spreads are behind us. Citing improved credit score high quality, aggressive Fed intervention, and a persistent scarcity of provide, they argue that future recessions won’t push excessive yield spreads to the extremes seen in 2020 or in prior downturns. However a more in-depth, data-driven examination reveals that these arguments are overstated or flawed. Actually, circumstances stay firmly in place for spreads to breach +1,000 bps once more within the subsequent recession, making it a mistake to dismiss that chance too simply.
Throughout the latest US recession, the danger premium over default-risk-free Treasury bonds tripled in a interval of lower than three months. The ICE BofA US Excessive Yield Index’s option-adjusted unfold versus (OAS) widened from +360 bps on December 31, 2019 to +1,087 bps on March 23, 2023. Over that interval, the excessive yield index posted a dispiriting -20.56% whole return, which in contrast unfavorably with fastened revenue options such because the funding grade ICE BofA US Company Index at -9.97% and the ICE BofA US Mortgage Backed Safety Index at 1.71%.
With that have nonetheless recent in institutional buyers’ minds, some excessive yield managers are understandably speaking down expectations that the OAS will widen to as a lot as +1,000 bps throughout the subsequent recession. Occasions have modified, they are saying, for the reason that recessions of 1990 to 1991 and 2001, when the unfold additionally surpassed +1,000 bps. Barring an financial contraction as extreme because the 2008 to 2009 Nice Recession, a repeat of that tough patch’s +2,147 bps peak unfold is unlikely.
Institutional gatekeepers fairly moderately count on one thing greater than a mere assertion that issues will likely be completely different this time round. Accordingly, excessive yield entrepreneurs have devised three rationales for proclaiming that the OAS will max out at 600 to 800 bps within the subsequent recession:
Higher excessive yield index credit score high quality than up to now.
Fed intervention aimed toward retaining the unfold properly under previous most ranges — the “Fed put” speculation.
Impact of a persistent scarcity of provide of excessive yield bonds.
All three are believable on their face, however none maintain up properly upon shut examination.
Higher High quality Than in Previous
This argument’s underlying notion is right. Bonds with the top-tier speculative-grade score, BB, have narrower spreads and widen out much less throughout recessions than these rated decrease: B, CCC, CC, and C.[1] Subsequently, if the excessive yield index is extra concentrated in BBs than in a given previous recession, it follows that in a future recession of equal magnitude the index’s total unfold ought to widen by lower than within the earlier occasion.
The ICE BofA US Excessive Yield Index does certainly have a bigger BB element than up to now, defining the previous as the common from the inception date of the index’s score subindexes, December 31, 1996 by means of December 31, 2024. The BB share of whole market worth averaged 44.53% over that interval. Against this, the determine stood at 53.55% on April 17, 2025, the statement date I utilized in a latest evaluation.
The April 17, 2025 BB share was solely barely larger than on March 23, 2020, the date of the utmost excessive yield OAS throughout the latest recession. Basing the evaluation on the latest recession avoids comparability issues that might come up from modifications which will have occurred within the score companies’ requirements over an extended interval.
For every score class within the index, I calculated a weighted-average OAS primarily based on the spreads of the bonds throughout the class. Then, assuming a recession of comparable high quality to the 2020 downturn, I utilized the weighted-average OAS to the April 17, 2025 rankings combine. The projected index unfold got here to not +600 bps or +800 bps, however +1,093 bps.
That projection’s small extra during the last recession’s +1,087 bps most was attributable to larger concentrations within the two lowest score classes, CC and C, than on March 23, 2020. The important thing level, nonetheless, is that the index’s a lot talked about enchancment in rankings combine is just not substantial sufficient to forestall a widening to +1,000 bps or extra throughout the subsequent recession.
Fed Put
Though the Fed’s legislative mandate is to take care of secure costs in step with full employment — slightly than to handle the spread-versus-Treasuries on excessive yield bonds — the central financial institution does take note of whether or not debt financing is out there to firms that lack high credit score rankings. The historic file displayed within the desk reveals, nonetheless, that intervention within the type of an preliminary discount of the Fed funds charge doesn’t cease spread-widening lifeless in its tracks. Fed easing might stop the excessive yield unfold from widening as a lot as it will have with out the intervention, however not, judging by expertise, from widening to at the very least +1,000 bps.
Persistent Provide Scarcity
Just like the others, the persistent provide scarcity rationale accommodates a kernel of fact. On our April 17, 2025 statement date, the ICE BofA US Excessive Yield Index’s whole face quantity was $1.4 trillion, unchanged from 10 years earlier. To a considerable extent, new issuance has migrated to leveraged loans and, in the previous few years, to non-public credit score. A big new difficulty quantity is required simply to maintain outstandings from declining as bonds mature, get referred to as, default, and rise to funding grade. Stagnant provide within the face of rising investable wealth is a recipe for continual overvaluation that might curtail spread-widening in a recession.
On the face of it, the supply-shortage argument is supported by the latest historical past of precise spreads on the excessive yield index, in contrast with honest values estimated by my econometric mannequin of the unfold. Traditionally, the precise unfold continuously swung forwards and backwards from cheaper then to richer after which honest worth. From October 2022 by means of March 2025, nonetheless, the precise unfold was lower than honest worth in each single month, in some instances by upwards of 200 foundation factors. It will not appear unreasonable, subsequently, to contend that when honest worth subsequent widens to +1,000 bps, the precise unfold will lag at, say, +800 bps.
The flaw in that reasoning arises from a sample noticed within the October 2022 to March 2025 interval of steady excessive yield overvaluation. There was a determined tendency, albeit in a small pattern, for the overvaluation to lower when the precise unfold elevated. Most dramatically, when the precise OAS widened by 39 bps in October 2023, the shortfall of precise OAS versus honest worth dropped by 100 bps.
This means that when the following onset of recession causes the precise unfold to widen by a whole lot of foundation factors, the availability scarcity won’t act as a firewall in opposition to convergence with a good worth of +1,000 bps or extra. As a substitute of provide being too small to fulfill demand besides at extreme valuations, there will likely be extra sellers than the consumers can accommodate besides at spreads a lot better than honest worth.
Key Takeaway
There are legitimate rationales for a strategic allocation to excessive yield bonds, together with their excessive present yield and low correlation with each funding grade bonds and equities. Tactical will increase in excessive yield publicity can at instances be justified on grounds of valuation or financial outlook. Excessive yield asset gatherers consequently don’t have any want to advertise the asset class primarily based on assertions that will not stand as much as scrutiny, corresponding to, “We are going to by no means once more see a +1,000-bp unfold.”
[1] Scores mentioned herein are ICE Indices Composite Scores, derived from rankings of Customary & Poor’s, of Fitch Scores, and of Moody’s Traders, which makes use of a unique however parallel notation system.
