As Credit Spreads Tighten, Look to Active Management

The potential for a soft landing continues to grow as the Fed indicates rate cuts later this year. A soft landing could cause further tightening in credit spreads, while a divergence from market expectations could lead to sudden widening. It’s an environment that favors active management strategies, whichever way the cards fall.

In recent months, the compression of credit spreads has proved beneficial for high-yield, bank loans, emerging markets, and corporate bonds. Credit spread compression happens when the yield differences between Treasuries and other bonds that share the same maturity shrink.

As Treasury prices fall and their yields rise, investors generally move into other debt instruments. This typically happens when the economic environment is positive or improving, causing narrower spreads. When the economic environment sours, investors sell out of riskier investments like corporate bonds in favor of the safety of Treasuries. This, in turn, causes the spread to widen.

“In January 2024, IG [investment grade] corporate spreads fell below 1% for the first time in nearly two years,” Mark Cintolo, CFA, CAIA, VP and portfolio consultant for Natixis Investment Managers Solutions, explained in a recent paper.

There’s some debate regarding the impact of reduced supply on the corporate bond side. In a high-yield environment, companies may be more reticent to issue debt. This leads to a supply and demand imbalance that can create artificially lower credit spreads compared to their fundamentals, Cintolo explained.