You will be able to read corporate credit spreads and explain why they widen before or during equity sell-offs.
Share prices are set by millions of buyers and sellers reacting to news, moods and each other. Bond investors are a duller crowd, and that's their value as a signal. A lender's question is narrow: will I get my money back? When lenders start demanding more to lend to companies, it often means something is going wrong underneath, and sometimes they notice before shareholders do. Marcus doesn't own any high-yield bonds. He watches their spreads anyway.
A credit spread is the extra yield a corporate bond pays over a government bond of the same maturity. With made-up figures, if a five-year bond from a company yields 6.5% and the five-year US Treasury yields 4.2%, the spread is 2.3 percentage points. That gap pays the lender for the chance the company defaults, for the bond being harder to sell, and for the risk that defaults bunch together in a downturn.
Index providers calculate average spreads for whole groups of bonds. Investment-grade spreads cover companies rated BBB- or higher, which are less likely to default. High-yield spreads cover companies rated below that, which pay more because they default more often. High-yield spreads are the more sensitive signal, because those borrowers feel a slowdown first.
You don't need to own bonds to use them. FRED, the St. Louis Fed's database, publishes daily series for US investment-grade and high-yield spreads from ICE BofA indexes. Check how many years of history it shows, and use a second source if you need a longer record.
High-yield spreads and share prices respond to the same thing: the market's view of company earnings and survival. So spreads tend to widen when shares fall, and narrow when shares rise.
The interesting cases are when they disagree. Sometimes spreads start widening while shares are still near their highs, a sign that lenders are getting nervous before shareholders. Sometimes shares fall sharply on a scare while spreads barely move, which suggests the bond market sees no real threat to companies' ability to pay. Neither pattern is reliable enough to trade on, but either one is worth noting.
Two episodes show the extremes. In 2008, high-yield spreads widened to levels that priced in a wave of defaults, and defaults did rise sharply in the year that followed. In March 2020, spreads jumped within weeks as the pandemic shut economies down. On 23 March 2020 the Fed announced it would buy corporate bonds for the first time, and spreads began narrowing almost immediately, well before the economy recovered.
Spreads tell you what lenders charge. Two other kinds of data tell you whether they're lending at all.
Bank lending surveys ask loan officers whether they are tightening or easing their standards. In the US, the Federal Reserve's Senior Loan Officer Opinion Survey does this each quarter, and MAS and other central banks publish their own credit data. When a growing share of banks report tightening, businesses and households find credit harder to get, which tends to slow spending a few quarters later.
Funding markets are where banks and large institutions borrow from each other for days or weeks. In normal times they work without anyone noticing. Under stress they seize up. In 2008 banks stopped trusting each other's ability to repay, and the cost of short-term interbank borrowing jumped far above the policy rate. In March 2020 even the US Treasury market, the deepest in the world, struggled to absorb selling until the Fed stepped in. Signs of strain in these markets, such as unusually wide gaps between short-term borrowing rates and the policy rate, are among the earliest warnings that a sell-off could become a crisis.
Any single indicator twitches for reasons unrelated to the economy: a big bond issue, a quarter-end, a sector-specific problem. If you act on every twitch, you'll trade far too often and mostly be wrong.
The useful signal is several indicators moving together. Spreads widening, banks tightening standards and funding markets showing strain at the same time say much more than any one alone. That's also how the regime check in lesson 3.1, Growth and inflation: four regimes and what tends to do well in each, works: you look for agreement across separate pieces of evidence.
Marcus keeps one high-yield spread series on his macro dashboard, which you'll build in lesson 3.8. He doesn't use it to trade. He uses it to decide when to reread his written rules and check that his cash and bond holdings would cover what he might need in a bad year.
For the activity, find the ICE BofA US high-yield spread series on FRED, note where it stands today against its range over the past ten years, and write one sentence on what that position implies about how worried lenders are.
Find a published high-yield spread series, note its current level against its ten-year range and write what it implies.
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