Credit Spreads: How Low Can They Go?

Executive summary 

1. Economic and monetary conditions are supportive. Growth is stable, default risk is low, and central banks remain accommodative.

2. Investor demand remains strong. Steeper curves, insurance and pension buying, and limited net supply all provide a firm bid for credit.

3. Relative value is nuanced. On an asset swap basis, spreads still look cheap to some investors, even if they feel tight relative to Treasuries.

History suggests a period of low volatility in spreads can persist, but turns can be sharp and effective positioning is important. Dispersion is still present, despite spreads being tight. Spreads could tighten further via dispersion compression between issuers. This gives active managers an opportunity to add value from picking bonds from companies offering additional risk premium, while ETFs seek only to replicate the performance of the index.

Introduction
Credit spreads—the extra yield investors earn from holding corporate bonds instead of risk-free government paper—are often described as the market’s barometer of confidence. Wider spreads typically indicate heightened market uncertainty, whereas tight spreads suggest a more stable outlook. Right now, spreads are hovering near some of their lowest levels in history. That raises an important question: how much further can they realistically fall, and what does it mean for future returns?

Historical context
The late 1990s and mid-2000s both saw prolonged periods of tight spreads. While there were inevitable ups and downs, the fluctuations were shallow compared with the turbulence of the 2010s. Could we be entering another era of spread stability? To answer that, we need to look at two things: what kind of environment allows spreads to stay tight, and whether today’s backdrop fits that bill. As shown in Figure 1, BBB spreads are 20bps from all time tights in 1997. Average duration is slightly longer today but remains comparable.

Driver 1. Macro environment
Two big forces have historically driven spreads wider: recessions and tighter financial conditions.

On the economic side, the primary concern for credit markets is the ability of companies to service their debt, and consequently the risk of recession. Earnings growth can slow and equity investors may fret, but unless businesses start to struggle with interest payments, credit markets tend to stay calm. Right now, the picture looks benign. Growth forecasts are being revised upward, recession risks have faded, and while government deficits are an obvious excess, corporate balance sheets remain generally healthy. Default forecasts and ratings trends show stability, not deterioration. The Moody’s baseline forecast sees default rates dropping, shown in Figure 2.

The monetary backdrop is equally supportive. Financial conditions are looser, and while spreads and financial conditions interact in a circular fashion, the direction of policy matters. The immediate outlook points to easier—not tighter—monetary policy. That keeps refinancing risks low and, unlike much of the past decade, central banks now have conventional room to cut rates if conditions worsen, rather than leaning heavily on unconventional tools like quantitative easing.

Put simply, neither recession or aggressive monetary tightening look likely to disrupt spreads in the near term.

Driver 2. Market dynamics
When macro risks are muted, spreads are increasingly shaped by market plumbing.

For one, lower cash yields are steepening yield curves. That matters. When money market funds paid nearly as much as longer dated bonds, there was little incentive for investors to extend duration. But now, with curves steeper, longer bonds offer more carry and more compensation for volatility. That makes them more appealing in a stable macro backdrop.

Structural demand also plays a role. Insurance companies and pension funds are buyers of credit, and they’re not going away. Surging annuity sales in the US are boosting demand for longer-dated bonds, even as companies hesitate to issue at today’s higher yields. This imbalance ofrobust demand chasing constrained supply supports further spread compression.

Interestingly, while corporate issuance has risen in nominal terms, the real stock of corporate debt has actually fallen. Inflation has expanded the monetary base faster than nominal debt levels, meaning there is less supply per dollar in circulation. Add to that the growing role of private credit, with large institutions providing direct financing even to investment grade giants, and the traditional bond market can feel supply-constrained.

Driver 3. Government Bond oddities
There’s also a curious twist in today’s market compared with earlier tight-spread eras. Government bonds are now yielding more than fixed-rate swaps (see Figure 4). Regulatory changes and ballooning government debt issuance have flipped this historic relationship.

Why does this matter? For investors who hedge interest rate risk through swaps, corporate bond spreads still look relatively generous. That suggests one group of investors (yield buyers comparing to Treasuries) may see valuations as rich, while another (spread buyers comparing to swaps) still sees value. This divergence could allow spreads to stay tighter for longer than historical comparisons might suggest,especially at the long end of the curve.

Final thoughts
For investors, this environment is a double-edged sword. The income available from credit is less about risk premia and more about the base level of yields—now considerably higher than in the last decade. With steep yield curves and an expectation of a stable to lower rate environment, there is incentive to extend maturities and bonds to once again beat cash, which is drawing in a wide array of structural buyers of income. That demand underpins spreads, even as valuations appear stretched.

With supportive macro conditions, strong structural demand, and new market dynamics, spreads could stay tight for longer than recent history might suggest. The takeaway? Don’t anticipate that credit corrections will be all that deep, absent a material economic shock.

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