Financial markets update: An improved outlook for corporate borrowing

Improved financial conditions, a dynamic labor market and wage growth that is exceeding inflation all should bolster corporate earnings this year in the United States.

Most important, with productivity improving, the potential for greater corporate profits and rising margins will be a theme in first-quarter earnings calls and for the rest of the year.

Now, with spreads on corporate bonds easing, borrowing by firms will bolster a sustained expansion and an economy that outperforms expectations this year.

Low corporate yield spread

The risk premium for corporate borrowing has declined to its lowest levels since the mid-1990s economic recovery. For example, the credit spread between investment-grade (Baa-rated) corporate bonds and 10-year Treasury bonds has dropped from 245 basis points in the first half of 2022 to 155 as of the third week of April.

We see this is as a vote of confidence in the economic recovery as well as the prospects for sustained profitability. 

How did we get here?

The yield spread between corporate bonds and 10-year Treasury bonds began its decline early in 2022. We like to think the bond market was at first quietly signaling the market’s affirmation of the Federal Reserve’s ability to restore price stability and sustain full employment.

But that has morphed into perceptions of the lower risk of corporate borrowing because of improved growth prospects. Now, it’s apparent that the genesis for these reduced spreads most likely resulted from the global search for yield.

At the end of 2021, 10-year Treasury bonds were yielding a paltry 1.5%, which made corporate bonds yielding 3.5% that much more attractive.

Add to that the currency return of a soaring dollar for foreign investors, and the demand for U.S. corporate bonds was off and running.

That created the conditions for the 77 basis-point decline in the yield spread between investment-grade corporate bonds and 10-year Treasury bonds since February 2022, a month before the Federal Reserve began hiking rates.

Over that same period, the spread between high-yield (higher-risk) corporate bonds and Treasury securities has trended lower as well, but with spreads still higher than in 2021.

We attribute that to the residue of risk demanded by investors holding bonds more likely to default should there be further geopolitical disruptions. The decline is encouraging, nonetheless.

Improved picture for corporate borrowing

The improving picture for corporate borrowing and lending is seen in the New York Fed’s Corporate Bond Market Distress Index, which peaked at the end of 2022 and has dropped to levels associated with past economic recoveries.

The index identifies periods of distress in the primary market, where corporate bonds are created, and the secondary market, where corporate bonds are traded. The index incorporates aspects of issuance, pricing and liquidity conditions.

We assign the decrease in distress to the lower risk of default and concurrent increase in liquidity. The economy has expanded despite elevated inflation and geopolitical shocks, which has reduced the probability of a recession and increased the willingness to borrow and to lend.

In addition, lifting interest rates off the zero-bound has nullified the distortions that have plagued the financial markets during the 15 years since the financial crisis, serving to increase participation in the market.

Increased demand for corporate debt

Another sign of the increased demand for corporate bonds comes from a recent report from the Securities Industry and Financial Markets Association (SIFMA), a trade association of broker-dealers, investment banks and asset managers. SIFMA reported a 20% increase in corporate bond trading last year, with most of that increase attributed to retail investors.

SIFMA noted that from 2021 to 2022, the average daily trade count of corporate bonds effectively doubled, hitting almost 100,000 a day. Growth has continued since then.

The yield on 10-year Treasury bonds has increased by 75 basis points this year, rising from 3.9% to 4.6% on April 18. But the yield on Baa corporate bonds has increased by 60 basis points, from 5.5% to 6.1%, further reducing the credit spread.

We would note, however, that with local banks now offering CDs with 6% yearly returns, the demand for corporate bonds by retail investors may wane. 

Continued growth

The prospect of the economy growing at its long-run potential implies corporate profits will continue to grow, leading to reduced credit risk.

We expect growth in real gross domestic product (GDP) to gravitate toward its long-term rate of 1.8% per year this year and next. After that, investments in infrastructure and technology will likely add to productivity and growth.

Corporate rates

The SIFMA report found that while retail investors drove the demand for corporate bonds, asset managers and price-sensitive hedge funds led the demand for Treasury securities.

We note that interest rates across all markets are driven by expectations of the federal funds rate plus compensation for the perceived risk of holding securities until maturity, referred to as the term premium.

We see the spread between corporate bonds and the base interest rates of Treasury bonds as a measure of that risk. As such, we see the decrease in that spread both as a result of demand for higher corporate yields and, more recently, as a result of the market’s continual reassessment of the path of Fed policy as it affects potential growth and the yield of 10-year Treasury bonds. That is, of the market’s continual reassessment of when the first rate cut will occur.

For that reason, the base for corporate yields remains the yield on 10-year Treasury bonds. We think a trading range centered on a 4.25% yield of 10-year bonds is therefore appropriate for the actual and potential level of economic activity.

The 10-year yield can be calculated in various ways, including as the sum of the real (equilibrium) yield required by investors (generally accepted to be 2%) plus the compensation for inflation, which is now around 2.25%. The result is a 10-year yield of 4.25%. Another approach is to add potential GDP growth of 1.8% to a new 2.5% rate of acceptable inflation, resulting in a 10-year yield of 4.3%.

At the start of the year, we expected the 10-year yield to move between 4% and 4.5%—and that is what is happening, with investors swinging from doubt about the resilience of the expansion to concern around the risks of overheating.

Given the move in the economy and interest rates moving toward our forecast, we are not changing our view on the 10-year yield or economic growth this year. 

Is there a bubble?

Bubbles in financial markets are transmitted to the real economy through a decrease in the willingness to borrow or to lend.

A large increase in corporate yields compared to the increase in Treasury yields would indicate increased financial market stress and the slowing of investment and economic growth.

Conversely, a large drop in corporate yields and spreads might indicate an asset bubble, with the potential for collapse leading to slower growth.

We doubt that the increase in demand for corporate bonds or the decrease in corporate yield spreads are cause for alarm. Rather, they reflect the normalization of interest rates after years of low-for-long interest rates.

In fact, financial conditions are neutral, with caution in the bond market balancing the exuberance in the equity market.

The caution in the bond market is driven by the Fed maintaining its tight monetary policy and by the lingering uncertainty about price stability and economic growth amid geopolitical threats.

We attribute the exuberance in the equity market to the decades of declining returns in the bond market, forcing stocks to be the only game in town.

And this is where a potential bubble exists. At present, the price-earnings ratio of the S&P 500 is once more moving toward the bubble levels of past cycles. That is, stock prices are excessively high compared to company earnings.

In the absence of any disruptions, we think the Fed will continue gradually reducing its overnight rate and issuing sufficient forward guidance. This should allow bond market spreads and other market assets (including the stock market) to assume their appropriate levels in an economy growing at its potential.

The takeaway

Corporate spreads are falling because of market assessments of current and potential economic growth and stability.

Corporate borrowing should continue unimpeded at interest rate levels that are appropriate for an economy growing at or above its potential.

We see the U.S. economy growing at or above 2% in the coming quarters, with 10-year Treasury yields trading in a range centered on 4.25% and investment-grade corporate debt trading with a credit risk premium centered on 1.5%.