The Market Metric That Predicts Trouble Before It Arrives A Note From Amanda: Hot stock alert! On Monday, Shah is going to share his latest "undefeated" play to a select group of readers. It's averaged 140% each March for the last 5 years... while the S&P has managed a paltry 0.4%! Get the ticker - and more details - right here.
 | | Shah Gilani
Chief Investment Strategist | Do you know why Venezuela's government pays 10.40% on a 10-year debt note while the U.S. only pays 4.27%? Venezuela is a higher investment risk. The rate difference is known as the "credit spread." And it's an invaluable tool to assess credit quality, gauge economic stress, and guide our investment strategies. Today, I want to demonstrate how to use credit spreads to help you make better investment decisions. The Role of Treasuries as the "Risk-Free" Benchmark In a nutshell, credit spreads are the difference in yield between various debt instruments and a benchmark. The U.S. Treasury notes, bills, and bonds are globally considered the gold standard. People call them "risk-free" because the U.S. government has never defaulted (Venezuela has), our economy is enormous, and we can always print more money. Why, then, do Treasuries pay anything at all? Because of inflation and opportunity cost. Treasury yields reflect investors' expected returns from risk-free investments over a specific period for both of these items. Anything a company or government pays on top of a debt note with a similar maturity is considered the risk premium. Understanding Credit Spreads Across Different Ratings Credit spreads vary based on the issuer's creditworthiness, with ratings assigned by agencies such as Moody's, S&P, and Fitch. These ratings range from high-grade (AAA) to speculative-grade (junk) statuses. AAA-rated bonds are top-tier securities with minimal default risk. The spread over Treasurys is typically very narrow, reflecting high investor confidence. BBB-rated bonds, situated at the lower end of investment-grade ratings, carry moderate credit risk. Investors demand a higher spread than AAA bonds to compensate for the increased risk. Junk bonds (below investment grade), also known as high-yield bonds, are issued by entities with significant credit risk. Investors require substantial spreads over Treasurys, typically 200 basis points (two percentage points) to several hundred basis points, to offset the heightened possibility of default. You can see the rates for the end of February in the graphic below from Fidelity: 
View larger image The Current Read Despite economic headwinds and tariff talk, credit spreads have remained tight. This suggests sustained investor confidence in credit markets. The ICE BofA U.S. High Yield Index Option-Adjusted Spread (junk bonds vs. Treasurys) stood at 268 basis points (2.68%) in late January 2025, just 22 bps above historical lows. Moody's Seasoned Baa Corporate Bond Yield relative to the 10-year Treasury yield was approximately 151 basis points on February 26. The graphic above puts the average 10-year credit spread for U.S. Treasurys and junk bonds at 1.24%, just a touch lower. AAA-rated bonds often trade with spreads of 30-60 bps over Treasurys. The current spread is 30 bps for 10-year maturities, which has remained consistent for the past year and a half. The tight spread for AAA-rated bonds reflects strong balance sheets and high credit quality for those companies. What Tight Spreads Mean Tight credit spreads, even amidst economic uncertainties, can be attributed to several factors: - Investor Demand for Yield: In a low-yield environment, investors seek higher returns, driving demand for lower-rated bonds and compressing spreads.
- Economic Resilience: Robust economic indicators, such as strong labor markets and corporate earnings, bolster investor confidence, mitigating concerns over potential economic slowdowns.
- Market Liquidity: Ample liquidity in financial markets ensures steady demand for corporate bonds, sustaining tight spreads.
Potential Risks on the Horizon While current spreads imply optimism, there are still risks worth watching. Inflation could erode bond returns, leading to a reassessment of risk premiums and potential widening of spreads. Unpredictable policy decisions like tariffs can introduce volatility, affecting corporate profitability and investor sentiment. Signs of an economic slowdown could increase default risks, prompting investors to demand higher spreads as compensation. Credit spreads are a vital indicator of market sentiment, reflecting perceived credit risk and economic stability. As of late February 2025, despite economic uncertainties, the tight spreads underscore prevailing confidence among investors. Remember, credit spreads are leading indicators. They often widen before showing up in other data. Monitor them closely in the coming months. Any sustained widening could signal economic troubles ahead. Cheers, Shah Want more content like this? | | | | | | 
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