One Number, Regime Change and Spreading Out

The investment world is filled with indicators that promise to predict the future. Most are about as reliable as a weather forecast beyond three days. But there is one signal that has served as the market's most dependable crystal ball for the past 50 years: the ICE BofA US High Yield Index Option-Adjusted Spread.

This spread measures the yield premium that high-yield bonds offer over Treasuries. Think of it as the market's anxiety meter. When investors are confident, they demand smaller premiums for taking credit risk.

When fear creeps in, that premium balloons. Over the decades, this spread has exhibited pronounced cycles that tell us more about where markets are heading than most analysts care to admit.

The spread ranges from narrow levels below 300 basis points during boom times to crisis peaks well above 800 basis points when the world appears to be ending. Because credit spreads tend to tighten during good times and surge during recessions, they provide early warnings for both equity markets and the broader economy.

More importantly for those of us who in the financial markets, different asset classes perform predictably under various spread regimes.

The Four Seasons of Credit Spreads

Understanding these spread regimes is like reading the seasons. Each has its own characteristics, and each rewards different investment approaches.

Low Spread Regimes (Under 300 Basis Points)

When spreads fall below 300 basis points, investors are essentially declaring victory over default risk. We saw this in 1997, during 2005 to 2007, in 2014, and again in late 2021. These periods signal investor confidence and economic strength. Risk assets usually enjoy steady gains with low volatility.

The 2004 to 2007 period provides an excellent example. Spreads stayed mostly below 300 to 400 basis points for an extended period. The S&P 500 climbed steadily, and high-yield bonds earned solid returns. Everyone felt smart about their investment decisions.

But here is the critical insight that separates professionals from amateurs: spreads rarely stay at extremes indefinitely. When ultra-tight spreads begin to reverse and rise off their lows, turbulence often follows. Credit spreads sometimes widen before the stock market peaks, serving as an early warning signal. During low-spread regimes that start turning upward, a defensive stance becomes prudent.

Moderate Spreads (300 to 600 Basis Points)

This range encompasses normal credit conditions outside of boom and bust extremes. Spreads often oscillate here during mid-cycle slowdowns or recoveries. These periods reflect a balance of growth and risk.

When spreads fall within this range, direction matters more than level. Falling spreads usually indicate an improving outlook coming out of distress. In 2003 and 2009, spreads fell from above 600 basis points down toward 400 basis points, coinciding with double-digit equity rallies and substantial high-yield bond gains as the economy healed.

Conversely, rising spreads in the 300 to 600 range can signal early recessionary warnings. Mid-2015 saw spreads climb from around 400 to 600 basis points amid an earnings slump and energy defaults. Late 2018 witnessed a move from approximately 320 to 540 basis points during Federal Reserve tightening. Both episodes produced small-cap stock declines and broader market volatility spikes as risk aversion rose.

High Spreads (Above 600 Basis Points)

Spreads above 600 basis points reflect significant credit stress, typically recessionary conditions or crisis aftermath. These risk-off regimes see investors demanding large default premiums. High-yield spreads breached 600 basis points during the 1990 to 1991 recession, the 2000 to 2002 technology bust, the Global Financial Crisis when spreads exploded to approximately 2000 basis points, the Eurozone debt crisis, the energy bust of 2016, and the brief COVID shock of 2020.

In these environments, risk assets fall deeply out of favor. Stock prices are typically depressed and volatile, high-yield bonds trade at distressed prices, and bank and real estate equities often suffer the most. Rising spreads above 600 basis points correspond to the worst equity market quarters. The S&P 500 plunged 22% in the fourth quarter of 2008 and 20% in the first quarter of 2020.

However, high-spread regimes also set the stage for massive rebounds. Once systemic fears peak, falling spreads from above 600 or 800 basis points have historically yielded outsized returns across risk assets. When spreads collapsed from approximately 1,100 basis points in March 2020 to 600 basis points by mid-2020 with unprecedented policy support, the S&P 500 surged roughly 20% in the second quarter of 2020, and high-yield bonds jumped 9%.

Similarly, after spreads peaked above 1,800 basis points in late 2008, the grinding decline in early 2009 coincided with the S&P 500 delivering 15% in the second quarter of 2009, with small-caps and beaten-down value stocks far outpacing. Buying when spreads are extremely high has often been richly rewarded, but such opportunities come amid severe economic crises when few investors have the nerve or liquidity to act.

The Art of Timing Reversals

The most valuable insights come from studying spread trend reversals, as these inflection points often mark major regime changes for asset returns. Two scenarios deserve particular attention.

From Tightening to Widening

When an exceptionally low spread cycle reverses to a widening trend, it often presages an equity market peak and cyclical downturn. The high-yield spread troughed at approximately 260 basis points in May 2007 and began climbing that summer. Equities eventually followed into the 2008 decline. Similar patterns occurred in mid-2014 and mid-2018.

Quarters that saw spreads rise off levels below 300 basis points have produced poor average equity returns, often negative for small-caps, as investors belatedly price in growing risks. Higher-beta and cyclical segments underperform, while defensive, quality stocks hold up relatively better. Prudent investors at these turning points rotate into safer assets or hedges well before the stock market shows signs of cracking.

From Widening to Tightening

When spreads decisively peak and turn downward, they signal easing financial stress and often mark the start of a powerful recovery. The best periods for equity and credit returns cluster right after spread peaks. In these spread-tightening regimes, lower-quality assets surge most. High-yield bonds see sharp price appreciation in addition to high coupon income, and small-cap and value stocks tend to rally dramatically.

The three months after the March 2009 credit spread peak provide a perfect example. The lowest-priced deep value stocks skyrocketed. The bottom decile of U.S. stocks jumped 163% from March to May 2009, vastly outperforming previous winners. This reflects how abruptly market leadership shifts at inflections. Previously defensive, resilient stocks lag, while bombed-out cyclical and value names outperform as the outlook brightens.

Asset Class Performance by Spread Regime

Understanding how different asset classes perform under various spread conditions provides the foundation for intelligent asset allocation decisions.

Large-Cap Equities

Broad equities thrive most when credit spreads are high but falling. The S&P 500 has averaged strong double-digit annualized returns in quarters after spreads peak above 600 to 800 basis points. The combination of valuation recovery and improving economic expectations provides a powerful tailwind.

When spreads are moderate and falling, S&P 500 returns are also robust as a favorable environment of solid growth and declining risk premiums prevails. By contrast, rising-spread periods have been challenging, especially from low starting spreads. In quarters when spreads rose off levels below 300 basis points, the S&P often struggled to achieve gains.

Small-Cap Equities

Small-caps exhibit an exaggerated version of the large-cap pattern due to their higher risk profile. In risk-on spread-tightening phases, small-caps typically explode upward. The Russell 2000 jumped approximately 45% in the four quarters following the 2009 spread peak, vastly outperforming large-caps.

However, in risk-off episodes, small-caps fare much worse. When high-yield spreads were climbing, particularly above 500 basis points, the Russell 2000 underperformed the S&P 500 in roughly 80% of quarters. The flight-to-quality dynamic makes smaller companies move in line with junk bonds, as deteriorating credit conditions hit smaller firms hardest while larger-cap safe havens hold up better.

Investment-Grade Bonds

The U.S. Aggregate bond index behaves very differently from equities. It tends to be a safe haven when spreads widen, thanks to its Treasury component. During many spread-widening episodes, Treasury yields fall due to flight-to-quality flows, which offsets price declines on corporate bonds.

In 2008, as credit spreads exploded, 10-year Treasury yields plunged more than 100 basis points. The Aggregate Index managed a 5% total return that year even as stocks cratered. Investment-grade bonds often post positive or flat returns in quarters of rapidly rising spreads, especially if accompanied by economic slowdown and rate cuts.

High-Yield Bonds

By construction, high-yield bond returns are tightly linked to the level and change of spreads. In quarters of falling spreads, high-yield bonds have averaged high-single-digit percentage gains, buoyed by both price appreciation and hefty coupon income. In rising-spread quarters, however, high-yield typically suffers losses.

Starting spread level matters significantly. Buying high yield at very tight spreads leaves little cushion, whereas buying at high yields often leads to strong forward returns. Yield-to-worst has been a powerful predictor of high-yield performance.

Bank Stocks

The performance of bank equities is closely intertwined with credit conditions. Banks are essentially in the business of extending credit, so when credit spreads blow out, their loan portfolios and funding costs come under stress. Banking sector indexes have seen sharp losses during each financial crisis alongside soaring spreads.

Conversely, when spreads tighten and the economy recovers, bank stocks usually rebound strongly as their earnings benefit from improving credit quality and rising loan growth. Bank stocks perform best in moderate, falling-spread environments and worst in sharply rising-spread environments.

Real Estate Investment Trusts

REITs rely heavily on debt financing and are economically sensitive, so credit cycle swings materially impact returns. In widening spread regimes, REITs often underperform due to higher borrowing costs and weakening economic demand for real estate.

In falling or low-spread periods, REITs can prosper. When credit is cheap and plentiful, real estate cap rates fall and property values rise, aiding REIT asset values. Economic expansions associated with tight spreads boost occupancy and rents.

The Style Factor Connection

The credit cycle also manifests in equity style returns, notably the classic value versus momentum dichotomy. Deep value stocks behave somewhat analogously to high-yield bonds. They suffer disproportionately during credit panics but outperform sharply during recoveries.

When spreads widen, deep value names are shunned by investors and can fall more than the overall market. Yet after spreads peak, value stocks tend to lead the charge. The snap-back of prior losers in 2009 was extraordinary. This pattern repeated in early 2021 with vaccines and stimulus, as many deep value pandemic casualties surged, outpacing the technology and growth winners of 2020.

On the other side, momentum stocks often exhibit opposite behavior. Momentum investing thrives when trends persist, but it struggles at turning points. When the trend suddenly reverses, momentum tends to experience whipsaw effects. The most famous example is the 2009 momentum crash, when previously losing stocks exploded upward while prior defensive winners lagged.

Practical Implications

Understanding credit spread regimes provides a framework for making better asset allocation decisions. When spreads are high and poised to tighten, overweight small-caps, value stocks, high-yield bonds, and REITs. When spreads are low or climbing, favor large-caps, quality stocks, and investment-grade bonds.

The key insight is that credit spreads often change direction before equity markets, providing early warning signals for regime changes. Rather than chasing performance or following the crowd, investors who monitor credit spread trends can position portfolios for the next phase of the cycle.

This is not about market timing in the traditional sense. It is about recognizing that different market environments reward different investment approaches. Credit spreads provide the roadmap for navigating these changing conditions.

Much of the quantitative analysis underlying this framework comes from the excellent research conducted by Dan Rasmussen and his team at Verdad Capital. Their comprehensive studies on high-yield credit spreads and asset class performance across different market regimes have provided invaluable insights into these relationships. Their work has helped illuminate the mathematical precision behind what many of us have observed anecdotally over decades of managing money.

The market has many fortune tellers, but credit spreads have proven themselves over five decades to be among the most reliable. Those who learn to read their signals will find themselves positioned for success regardless of what the economic cycle brings next.