Can spreads tighten further in 2025?

January 7, 2025

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In his latest column on the key developments, themes and opportunities in credit markets, Ian Horn attempts to answer the big question on the minds of bond investors heading into 2025.

Over the last 3 years, we have seen a significant shortening of European credit markets. High-yield companies have preferred to leave bonds issued prior to the recent interest rate-hiking cycle outstanding for longer, maximising the benefit of their low coupons, whilst companies broadly opted to issue shorter-dated bonds when funding costs were elevated.

Meanwhile, longer-dated bonds have fallen in price, meaning they represent a smaller part of the market than they have historically. These factors have collectively resulted in European corporate bond markets today being significantly shorter than they were at the end of 2021, as Figure 1 illustrates.

Shorter duration, tighter spreads

Shorter duration markets are supportive of tighter spreads. Spread curves are typically upward sloping – in other words, the longer a bond’s duration or maturity, the more spread is needed to compensate the lender for the additional risks. More obviously, higher credit quality is also supportive of tighter spreads.

To fairly judge the value in credit spreads, we therefore need to adjust them for credit quality and duration.

In Figure 2, we break down the European investment-grade market by rating - single-As and BBBs. This removes the impact of market-wide changes in credit quality that could be missed in a time series of broad market spreads. We then divide market spreads by market durations, thus adjusting spreads for the market’s duration at any time. This essentially gives us a rating-based ‘spread per unit of risk’, with the risk here defined as duration.

Much ado about nothing?

The chart shows that for each year of a bond’s duration, BBBs on average currently offer investors almost 30 basis points (bps) of spread, whilst single As offer around 20bps. By this measure, European investment-grade spreads appear to have significant room to tighten further, particularly BBBs. At the end of 2024, European single As and BBBs were offering approximately 50% more spread per unit of duration compared to the tights seen in 2018 and 2021.

By adjusting for duration and credit rating, we get a better sense of compensation per unit of risk. Investor concerns around spread valuations may be alleviated if we acknowledge the risks that those spreads reflect are also lower than in the past.

Figure 3 shows unadjusted investment-grade spreads as well as the level that would be consistent with spreads returning to their 10-year tights on a duration-adjusted basis.

If the theme of tighter spreads were to continue in 2025 and duration-adjusted spreads reach the tights seen in 2017, we estimate this could generate around 2% of excess return in single-As and BBBs. This is simply calculated by multiplying the implied spread tightening (shown in Figure 3) by current market durations.

Too tight or just right?

Should the recent strong demand for credit persist, and macroeconomic and political uncertainty remain manageable, our analysis would suggest we are still some way off the lower limit for spreads. Therefore, further spread tightening should perhaps not be a surprise, particularly in an environment of historically high yields.

Investors would be well served to remember the limited information that can be gleaned solely by looking at index-level spreads, even if they often drive market sentiment and headlines.

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. References to specific companies are for illustrative purposes only and does not reflect the holdings of any specific past or current portfolio or account. The opinions expressed by Muzinich & Co. are as of January 2025, and may change without notice.

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Index descriptions

ER00 – The ICE BofA ML Euro Corporate Index tracks the performance of EUR denominated investment grade corporate debt publicly issued in the eurobond or Euro member domestic markets. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million.

HE00 - The ICE BofA ML Euro High Yield Index tracks the performance of EUR dominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million.

ER30 - The ICE BofA Single-A Euro Corporate Index is a subset of the ICE BofAML Euro Corporate Index, including all securities rated A1 through A3, inclusive.

ER40 – The ICE BofA BBB Euro Corporate Index is a subset of the ICE BofA Euro Corporate Index, including all securities rated BBB1 through BBB3, inclusive.

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