What Credit Spreads Reveal About Diverging Corporate Financing Conditions Abroad
Broad overseas markets have remained resilient over the past two weeks, but corporate bond markets are showing signs of divergence. The weaker a company's credit quality, the more sharply the risk premium on its financing has risen.
That risk premium is known as the credit spread.
Put simply, a company must pay compensation for its credit risk on top of the underlying market interest rate. Better credit quality means a smaller premium; weaker credit quality means investors demand more. The logic is similar to bank lending: riskier borrowers face higher borrowing costs.
What exactly is this additional premium?
A company's bond-financing cost generally has two components. One is the benchmark interest rate—the yield investors require to lend to the government. The other is the credit spread. Regulators do not set credit spreads directly. They emerge through bond market trading and reflect how investors price the risk of corporate default: how much extra yield must a company offer to compensate investors for taking that risk?
The bond market has diverged noticeably over the past fortnight
According to ICE BofA index data, credit spreads on lower-rated high-yield bonds widened from 2.68% on September 18 to 3.24% on October 1, an increase of 56 basis points in just 13 days. The change was much smaller for higher-quality investment-grade corporate bonds, whose spreads rose from 0.77% to 0.86%, an increase of only 9 basis points.
The conclusion is clear: corporate bonds are not weakening uniformly. Companies with poorer credit quality are facing greater financing pressure in this episode.
Interest rates and credit premiums are rising together
As discussed above, a company's overall financing cost consists of a benchmark interest rate and a credit spread. Between September 22 and September 30, the 10-year US Treasury yield rose from 4.96% to 5.29%, an increase of 33 basis points.
These changes in benchmark rates and credit risk pricing cannot simply be added together, because their maturities and statistical definitions differ. But their simultaneous increase indicates that the corporate financing environment is tightening.
Although conditions have tightened considerably compared with the recent past, they have not reached the most stressed levels seen over the past three years. Nevertheless, a warning signal has appeared: markets are reassessing companies' ability to service their debt.
Why does this matter beyond financial markets?
Credit spreads and benchmark interest rates together determine companies' borrowing costs. If overall financing costs continue to rise, companies will become more cautious about expansion and investment. This may not immediately lead to large-scale layoffs, but it will reduce their willingness to hire, expand operations and launch new projects.
We should therefore examine both indicators together to assess corporate financing conditions. If those conditions tighten and companies scale back investment and hiring, the effects will eventually reach people's employment and income.