My experience as a bond trader and fixed-income portfolio manager during the Asian currency crisis, the Worldcom and Enron bankruptcies, as well as the Great Recession has given me a unique perspective on risk. As we enter the final three months of the year, the “Bond Guy” in me thought that it would be helpful to take stock of what is happening in the bond market, as it often picks up on changes in the economy that other sectors of the financial markets are slow to recognize.
Bond investors focus on the risk of recession and inflation, as these risks can reduce or sometimes eliminate the expected returns from bonds. Looking at how investors value sectors in the bond market and how the bond market is pricing certain risks can give us a good idea of how bond investors view the risk of a recession or a rise in inflation. Three particularly helpful indicators are: corporate bond spreads, the 2-10 year spread, and the 10-year breakeven inflation spread. These indicators can be found on the St Louis Federal Reserve’s economic data website: https://fred.stlouisfed.org/.
To gain insight into how the bond market sees the risk of a recession as well as the health of the balance sheets of corporations, my favorite indicator to look at is the BBB corporate bond spread as shown by the ICE BofA BBB US Corporate Index Option-Adjusted Spread. It shows us how much extra-yield bond investors demand when investing in a BBB-rated bond issued by a US corporation instead of a US government bond, which has virtually zero risk of default.
The chart above shows bond investors require 1.15% of the extra yield relative to a US Treasury note. Over the last 20 years, the additional yield required by bond investors to invest in BBB-rated securities has averaged 2.0%. The lowest amount of extra interest bond investors have required is 1.07%. When the market requires a low level of extra yield, it is a sign that bond investors see a lower-than-average risk of corporate defaults and, by extension, a lower risk of recession over the near term. The highest spread we have seen was in December of 2008 during the financial crisis when it hit 7.98%. The downward trend in the spread over the last year indicates that bond investors see corporate balance sheets and the economy as strong.
On the risk of inflation, the bond market can tell us how bond investors view the risk of future inflation. One indicator that can help us see how the market views inflation is the 10-tear breakeven inflation rate. It takes the yield on a 10-year US Treasury note and compares it to the yield on a 10-year US Inflation-protected note. The difference in yields is the implied inflation rate bond investors expect over the next 10 years. The chart below shows that the current 10-year breakeven inflation rate is 2.21%. Over the last 20 years, the average has been 2.09%, and the median is 2.19%. The highest this number has been is 2.94% in March of 2022, which coincides with inflation hitting its highest level after the pandemic, and the lowest level was 0.11% in December of 2008, the height of the financial crisis. So, the 10-year breakeven inflation rate shows that bond investors are not worried about inflation over the coming years.
Finally, one indicator that has become very popular over the last few years is the 2-10 yield spread. The 2-10 spread, or the difference between the 2-year and 10-year Treasury yields, is a common indicator of the yield curve’s steepness. A negative 2-10 yield spread, or “inverted yield curve,” has historically indicated an impending recession. A yield curve is considered inverted when long-term interest rates fall below short-term rates. An inverted yield curve leading to a slowing economy makes intuitive sense, as many consumer loan rates, such as credit card and car loans, are tied to short-term interest rates. If short-term rates are high, consumers and businesses will slow their spending due to the high cost of financing. The 2-10 yield spread turned negative in July of 2022 in reaction to the Fed raising short-term interest rates. At the time, many market observers pointed to the inverted yield curve as a sign that the economy was heading into a recession. The 2-10 yield spread stayed negative until August of this year, when the spread finally turned positive, as the yield on the two-year treasury fell in anticipation of the Federal Reserve lowering short-term interest rates at its meeting at the end of September.
As we see from the chart above, the yield curve becoming inverted two years ago has not led to a recession. Has the indicator lost its value? One reason the inverted yield curve did not cause a recession may be that most borrowers took advantage of the low interest rates in 2021 to reduce their exposure to short-term interest rates. Consumers refinanced mortgages and used the extra cash flow to pay down credit card and auto loan debt. In April, a New York Times article said that 70% of all mortgage holders had rates more than three percentage points below what the market would offer them if they tried to take out a new loan. So, the subsequent rise in short-term rates did not affect the economy as much as it would have in the past. The spread turning positive in early September indicates that the bond market expects the Fed to reduce short-term interest rates over time in reaction to the inflation rate, which is now closer to the Fed’s long-term target.
In summary, the bond market can give us insights as to how investors view the risk of a recession as well as the risk of inflation. It’s signaling that bond investors are not overly concerned with a recession or inflation. It seems that the equity markets would agree, as the S&P 500 recently hit an all-time high. These indicators can and do change, so it is important to keep an eye out for changes in the bond market that can alert us to changes in the economy.