Risk of Default Declining
We like to use credit default swaps (a product that pays out investors if a reference company defaults) to track risk premiums in the corporate bond market. When risk premiums rise, credit default swaps get more expensive, and the spread implied between risk free rates and CDS rises. Click here to learn more about Bespoke’s premium stock market research service.
As recession fears intensified throughout the first half of 2022, both the investment grade and high yield credit default swap indices skyrocketed, gaining 106.7% and 110.5% between the start of the year and the highs, respectively. However, earnings were not as bad as feared, economic data is starting to come in better than expected, gas prices have fallen, and CPI seems to have peaked in June. All of this has caused substantial declines in CDS index spreads, with the risk premium associated with each falling by about a quarter since their summer peak.
Although CDX High Yield’s spread is well off of its highs, it is still above the average over the last ten years, implying a still elevated risk related to recession and potential defaults. We can also tie CDS indices to the performance of actual corporate bonds. The option-adjusted spread (a proxy for the credit risk over risk-free rates for a given investment) for high yield bonds in the “cash” market has a 0.88 correlation to CDS over the past decade. Notably, the CDX HY spread remains above its long-term average, while that High Yield Average OAS is below its average, implying investors may be getting under-compensated for the risk they are taking in the high yield debt market. Click here to learn more about Bespoke’s premium stock market research service.