Junk Bond Traders Ought to Check In With Economists

Corporate junk bonds in the US are paying investors a paltry premium for the risk of holding them into a looming recession. Either spreads need to widen or the recession clouds need to vanish, but something’s got to give.

Consider the first possibility, the base case. Junk spreads typically track recession risk closely, and the economic gloom has been mounting consistently for the past nine months. In particular, the median economist in Bloomberg survey data projects a 50% chance of a recession in the next year, and indicators based on the yield curve keep warning of a downturn, too. Yet high-yield spreads are still sitting at 4.52 percentage points over the Treasury curve on an option-adjusted basis, in line with their average over the past decade, according to the Bloomberg US Corporate High Yield index.

If you believe economists are right, then surely that spread will widen. Economists may have a lousy record at calling recessions, but that’s usually because they’re too conservative. They fail to foresee recessions or are too late but almost never forecast ones that don’t come to pass, as an IMF working paper found. In that sense, economists are at the the opposite end of the hysteria spectrum from equity markets, which get riled up about false signals all the time.