Wider spreads are not a default warning, they're a repricing of risk, says Ryan Domsy
Credit spreads are widening for the first time in a long stretch. After sitting near their tightest levels since before the great financial crisis (GFC), one expert underscores how spreads have started to gap out, driven by geopolitical tensions and a creeping sense that markets have been underpricing risk for too long.
“It was getting to quite tight levels, which for credit spreads, means that there's not a ton of value left in that specific component of the asset class. And so with the current geopolitical scenario, what we've seen is a bit of risk off sentiment start to leak into the market,” explained Ryan Domsy, head of fixed income and EVP at Foyston, Gordon & Payne Inc., “And given credit spreads have been so tight, naturally it did make sense for them to see some widening. In general, credit spreads still haven't widened a ton, relative to the significance of the current political environment. Still, they have widened, and that has changed the landscape from what we would have been speaking about just a month ago.”
For pension funds, credit should “always be viewed as an opportunity,” said Domsy, but how that opportunity is captured depends on the approach. For example, a passive allocation to a corporate bond index forces an investor to time market sentiment, which is difficult to do well.
Whereas active management, by contrast, allows a manager to lean into safer positioning “during exceptionally tight periods and then can capitalize on redeploying that capital into the segments of the market that have widened," he noted.
Reallocating at the pension level is a slow process, so the flexibility has to come from the manager already in place. In the current environment, he said, an active manager can be nimble and "start adding some selective risk into the portfolio where they feel they're being compensated appropriately."
Wider spreads don’t signal that investors are bracing for defaults, Domsy explained. If default risk were the real concern, spreads would be moving far more than they have. The shift is more about compensation and repricing. Investors are less certain about the economic outlook and where markets are heading, and they are demanding a higher premium before putting capital to work.
"It doesn't mean that they think everything is about to have a big problem, but what it definitely means is that they're cautious and that they want to get compensated more in order to take it," he said, adding he sees value in the repricing, particularly as prolonged tightening erodes the gap between strong and weak credits, and a shakeout forces the market to differentiate again.
"When you're in periods where spreads just keep tightening across the board, what you tend to lose is the differentiation between different types of companies and the bonds that they offer," said Domsy. Even with the recent widening, spreads remain tight by any measure over the past 15 years.
Notably, the widening in credit spreads isn’t limited to public fixed income as Domsy highlighted alternative and fixed-income-like assets – private credit, leveraged loans, private debt – are also seeing shifts in their inferred credit spreads. But he does draw a distinction between what is driving the moves in each corner of the market.
In public fixed income, the widening is recent and tied to geopolitical tensions, while in parts of the private and leveraged loan markets, the weakness predates the current environment.
"That was driven by more aggressive risk taking in some of those markets. That has translated into losses and, as a result, some higher credit spreads or some potentials to impairments on the underlying assets," noted Domsy.
While he underscored it’s still too early to identify one part of the credit market as the clear epicenter of stress from a business-risk standpoint, from an investment perspective, the pressure is showing up more clearly in lower-quality borrowers than in large-cap issuers with stronger balance sheets.
He suggests the widening is more visible in subordinated debt and in regional companies with narrower business exposure, especially those that may be more vulnerable to rising input costs or less able to pass those costs on to customers.
Despite the recent widening, though, Domsy believes the market is still in a defensive phase. While spreads are signalling that investors want more compensation for risk, the move “hasn’t really truly capitulated,” to suggest the market has fully absorbed what is happening globally. Part of the reason, he suggests, is that a large segment of the market is still hoping the current disruptions simply fade away.
The bigger concern is what comes next. First-order effects are already visible, but the second-order impacts depend on how long the disruption drags on. Prolonged supply chain strain, elevated oil prices, and stress in the fertilizer market will eventually feed into inflation and the food supply chain, and the longer those pressures persist, the larger the downstream consequences.
For now, much of that impact is still waiting to show up as the weakness is more evident in leveraged loans and other higher-risk US credit segments, particularly among smaller and mid-sized companies that rely on private or bank-based borrowing. Contrastingly, investment-grade credit still looks relatively resilient, especially in Canada, where spreads have widened only in a measured and manageable way, Domsy noted.
Ultimately, the most important message for investors, Domsy says, is to manage risk carefully in this kind of environment. After all, “deploying too quickly” is the biggest mistake, and the pressure to put capital to work shouldn’t override the need to do proper due diligence on each investment.
To that end, preserving capital should be the priority because permanent losses weigh heavily on long-term performance. That means taking the time to research companies and confirm they are on solid footing before buying their debt as wider spreads on their own don’t always justify an investment.
"It's only attractive if credit spreads are wide and there's not a significant increase in risk for that company on the other side," he said.
