Key takeaways

  • The yield advantage on corporate and high-yield bonds has been narrow for some time—a sign that economic conditions support corporate borrowing.
  • The war in Iran sparked a widening of yield spreads that could continue if oil prices stay elevated, analysts say.
  • When spreads are narrow, investors must take on more risk to earn higher yields in the corporate bond market.

As ripples from the war in Iran spread across global markets, yields on corporate and high-yield bonds tick higher, potentially alleviating a long-term drought in income on riskier corners of the bond market.

For years, credit spreads—a measure of the extra yield that bond investors earn while holding riskier bonds relative to “risk-free” investments like US Treasuries—have been unusually narrow. When spreads are tight, it implies investors are more confident that riskier corporate bonds will avoid default. That’s a sign of optimism about both corporate fundamentals and the overall health of the economy. The downside is that bond investors must take on more risk to earn a higher premium, or yield, over Treasury bonds. Narrow spreads also mean less cushion if yields fall and economic conditions deteriorate.

Analysts say that credit spreads could widen if oil prices stay elevated. Generally speaking, credit spreads widen in times of rising recession fears or stress in specific sectors. The Iran war has contributed to short-term economic uncertainty and rising oil prices—early indicators of widening in credit spreads that investors are watching.

Prior to the start of the war, the gap between the options-adjusted yield on the Morningstar US Corporate Bond Index and a risk-free investment shrunk to 0.83 percentage points, a narrowing relative to where it stood two years ago at 0.93 percentage points. The difference has been even more pronounced when it comes to riskier, high-yield debt.

In addition to a long cycle—analysts say the forces keeping spreads tight today can be traced back to the 2008 financial crisis—the bond market is grappling with an enormous surge in AI-related debt issuance by tech corporations, and more recently the US war with Iran. Here’s what investors need to know.

Why have credit spreads been so narrow?

Corporate bond spreads have been shrinking for the better part of a decade thanks to a potent combination of factors. “We’re in a period of benign conditions in terms of the outlook for credit risk,” explains Jeffrey Rosenberg, a senior portfolio manager within BlackRock’s systematic fixed income group.

For one, a growing economy in the aftermath of the covid-19 pandemic produced healthy corporate balance sheets, giving investors confidence that default risk in the corporate sector was low. “That’s very supportive of taking credit risk within portfolios,” says Matt Wrzesniewsky, head of fixed income client portfolio management at Vanguard.

Those conditions have allowed corporations to more easily access financing and issue more debt. At the same time, lower interest rates than in previous decades mean interest expenses are less of a burden on balance sheets. All that translates to more confidence for bond investors and more demand for corporate debt, which pushes prices higher and yields lower relative to Treasury bonds, tightening credit spreads.

There’s also a lot less junk in the high-yield bond market to begin with, as much of the riskiest debt has shifted to the leveraged loan or private credit markets.

Concerns about fiscal instability and growing government debt may have also contributed to investor appetite for corporate debt, adds Wrzesniewsky. “There might be a little bit more comfort in taking corporate credit risk where [bond investors] can really understand the fundamentals, versus some of these fiscal worries that come to mind when you start to look at governments have been operating at a deficit for a long period of time.”

Are narrow credit spreads a risk for investors?

Narrow spreads are a common phenomenon. “Credit spreads can actually remain narrow for very long periods of time,” says Vanguard’s Wrzesniewsky, pointing to multi-year periods in the ’90s and 2000s.

But that doesn’t mean they don’t carry some risk for investors. When credit conditions are this benign for a long time, BlackRock’s Rosenberg explains, those conditions could prompt borrowers to underestimate risks. “The complacency kicks in,” he says.

War in Iran widens spreads

Even within a longer cycle, short-term shocks can have a major impact on credit spreads. Most recently, spreads widened dramatically at the beginning of the United States’ war with Iran.

On Feb. 28, the difference in yields between a basket of BBB-rated corporate bonds and Treasury bonds of similar maturities hit 108 basis points—up from 101 basis points the previous week and a low of 93 basis points at the beginning of the month—as investors grappled with new uncertainty and risk in global financial markets. That shift, along with rising oil prices and the threat of an inflationary (potentially recessionary) economic shock, made corporate debt look a lot riskier for bond investors.

Spreads could remain wider if the conflict persists, analysts say. “A longer war would mean larger and more prolonged oil price shock,” wrote Bank of America analysts recently. “That scenario is beginning to have a significant negative impact on stocks, making it hard for spreads to rally [or shrink] even if yields remain attractive.”

BlackRock’s Rosenberg says a sustained spike in oil prices could also alter the forecast for economic production and growth. “In such a situation bond, yields may fall on fears of the growth impact,” he explains. “The decline in risk-free yields coupled with higher risk of growth impact would combine into a much larger surge in corporate bond spreads.”

The bottom line for investors

Analysts say the ebb and flow of credit conditions is normal. “There is always a credit cycle, but with unknown and uncertain timing,” says Rosenberg. As is usually the case in financial markets, the disruptions those unknowns create can mean opportunities for savvy investors. That’s true even if the outlook becomes more uncertain and yields creep higher.

“Yield is the engine of a bond,” says Vanguard’s Wrzesniewsky. “If you’re underwriting your positions and you’re doing your homework and you have conviction in the credits you’re owning, higher yield is giving you better returns, which is really what people care about in portfolios.” Take the massive corporate borrowing that has fueled the AI infrastructure boom. While uncertain returns on AI may have bolstered credit risk in some areas of the market, Wrzesniewsky says it has also fueled dispersion among sectors, “creating a bond pickers’ market.”