Credit spreads: Is there something you're not telling me?

Given the comparative health of IG corporate balance sheets, could spreads over government bonds turn negative?

Historically in recessionary periods or times of crisis, the widening of corporate bond spreads is offset by a rally in government bonds, providing an element of protection. However, governments have provided a strong fiscal impulse, taking on substantial levels of debt, when growth is still reasonably healthy. As Lord highlights: “The fact we are worried about fiscal risks when the sun is shining is concerning.” In a recessionary scenario, tax revenues will drop while government expenses rise, meaning governments would need to borrow more to fill that hole. Ryan likens running a government to running a household budget; the recent leap in debt burdens, he says, is akin to having your mortgage rate doubled or tripled in cost, eating up spending power and rather than reining it in and borrowing more and more on the credit card.

If governments continue to take on higher debt loads, it could create a scenario where a risk-off event, such as a recession, could see credit spreads move wider, while government bond yields remain elevated, leaving the developed world in a fiscal crisis. At this point, higher quality names could trade at government bond yields or lower.

“In this scenario, our long-term valuation framework of taking credit risk when we are paid for it would have reached its extreme conclusion,” Lord says.

However, while this scenario could occur, it is unlikely to be long-lasting. Companies operate within a legal framework. If the public sector is struggling for money while the private sector remains relatively strong, governments will turn to both wealth taxes and corporation taxes to take resources.

Furthermore, governments will be able to pull the levers of the printing press and quantitative easing, making a default highly improbable. Instead, the economy would face inflation and the devaluation of currencies, which would present different opportunities and different threats to companies.

Nevertheless, as Lord highlights, it is important to be asking whether government bonds do offer a risk-free rate or whether they will find themselves in the crosshairs of the bond vigilantes in a risk-off event.

“If the central bank was to lower rates without having the economic backdrop to warrant it, then you start getting worries around Fed independence and so on, [and] that’s going to cause problems across all markets – not just emerging markets (EM),” Smallwood argues.

Political intervention in the central bank could call into question the credibility of policy in the US, undermining a key stabilising factor in its financial system.

Muddying the picture further

Another risk facing corporate bond investors lies in assessing the image of corporate health. There has been an increased prevalence of liability management exercises (LMEs). Default rates are currently elevated but stable. However, this may not be the full picture. LMEs are essentially a debt restructuring technique where a company can alter existing debt, sometimes forcing losses onto creditors. This aggressive company behaviour can distort default numbers. According to Ryan: “If you include LMEs, the default numbers would be elevated and we would see a reaction in spreads, yet they remain low.”

As Ryan points out, prior to the GFC there was a belief that economic cycles were a thing of the past and therefore it was possible to take on more leverage without fear of a recession. However, “that leverage built and built, until it cracked,” he says.

The advent of private credit has also served to obfuscate the picture, providing borrowers with avenues to avoid “default in the traditional sense, and instead default by the back door,” adds Lord.
 

Zooming in

Having considered the risks posed to corporate bonds on a macroeconomic level, it is equally as important to consider the microeconomic shocks. This was demonstrated in early 2025, as China unexpectedly pulled ahead in the AI race. The release of the DeepSeek AI chatbot in January 2025 demonstrated how a single company can have a profound impact on not just a sector, but a whole market.

Ryan highlights household names that have disappeared such as Kodak, Polaroid and Nokia. “Companies can come along and change our marketplace, but there is always another company nipping at your heels and the whole world could change again,” he argues.

“We need to be humble enough to know that we might not see these things coming, but they will have an outsized effect on the marketplace.”

While a single disruptor can pose a risk to a whole market, the remaining companies can still provide opportunities for fixed income investors. Ryan highlights Xerox as a good example; fewer people use its products and there is a visible path of decline. However, if you are being paid a substantial risk premium that takes these factors into account, the firm could still present an attractive possibility. For a bond investor, we believe it is a risk worth taking if you are being paid to do so.
 

The name of the game

Given the complex, volatile landscape, accompanied by generationally tight credit spreads, how does an investor navigate this?

For Lord, if the largest proportion of IG yield is coming from the government bond yield, then it makes sense to reduce credit risk and add risk through a long duration position in government bonds.

“I’ve always done the same thing when spreads get down to these levels: sell risk and wait for a correction. It can take a long time or happen quickly, this time it is taking a long time for risk to correct,” he says.

However, Lord argues that “something always comes along – you never know what it is, you cannot predict what it is, but you can look at valuations; we use spreads in credit risk terms and when they are this tight you sell and you wait.”

Ryan agrees, adding: “There is a huge amount going on in each jurisdiction and I think people are struggling to assess that risk.”

In this scenario, it is important to be nimble and ready to react when valuations reach attractive levels again, because the market tends to sell off suddenly and rapidly.

For example, while certain spreads widened to an extent in the bout of tariff-related volatility in April 2025, markets were quick to retrace and it was a very short window of opportunity. Furthermore, markets didn’t experience a full sell-off, with only certain sectors such as autos, pharmaceuticals and to some extent travel selling off to attractive levels, offering a fleeting chance to go out and buy.

“For us at the moment, it is a question of being confident in the knowledge that even if we don’t know what is going to happen, something will come along and present an opportunity – it always does,” Ryan adds.

The current complacency exhibited by markets, while dangerous, offers active managers a potential to pick up the pieces when something eventually cracks.

“Our goal is to be the last man standing when the market cracks,” Ryan explains. “To be the person picking up the pieces and buying into these assets. The great thing about being able to do that is you don’t need to buy the riskiest assets at that point, [because] good quality assets are really cheap and you can make decent returns.”

In the meantime, Ryan prefers to take advantage of sectoral shifts, “which helps you put runs on the board and keep yourself ticking along, waiting effectively for that opportunity where you can really meaningfully change the risk profile.” Discipline and agility is the name of the game.
 

An emerging opportunity

Similarly to DMs, corporate credit spreads in EMs are also tight. However, in EMs, this is reflective of strong fundamentals: most corporates are not too indebted, balance sheets are strong and local rates are coming down.

However, as Smallwood points out, despite this strength, “you do still get paid more to be in EMs, even in IG.” He highlights that this has been reflected in flows as DMs investors have been “looking to get a bit more bang for their buck out of EMs, particularly in IG.”  

EM corporate bonds offer investors an opportunity to pick up extra yield without forgoing credit quality.