US sovereign risk distorting the message from credit spreads

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VP Research

NotesAsset AllocationUSnoramGlobal Macrosingle stockdmfixed income

Credit spreads have been compressed by rising US sovereign risk premia pushing up the “risk free" Treasury yield. Adjusting for these sovereign risks, high yield (HY) credit spreads are merely at post-GFC averages. Rather than prematurely reducing credit exposure, we think it is more effective to hedge credit exposure via long March 2026 SOFR (bet on more Fed cuts) and/or long TLT puts (take advantage of falling volatility).

The latest fall in HY credit spreads has coincided with elevated US sovereign risks, proxied by the 5Y CDS premium for US federal debt, for example.

At first glance, low credit spreads would imply 1) a benign economic outlook and 2) high credit valuations. We think both of these are overstated. Adjusting for elevated US sovereign risks pushing up the “risk free” component of the spread, HY credit spreads are just above their post-GFC average.

This level of the HY credit spread is more consistent with our “bending but not breaking” growth outlook for the US economy: while most coincident and leading indicators point to resilient growth, we are waiting for more evidence that labor markets are not deteriorating further. (See our Note.)

Adjusting for sovereign risk also leaves scope for credit spreads to remain low or fall further if the economy avoids recession but fiscal concerns linger in the US and elsewhere. After all, the rise in long-end bond yields has been even more pronounced in other major DMs.

To add to this, our tactical models point to a rise in US long-end bond yields over the next 1-3 months. Our aggregate net active tactical signals triggered a sell, which has reliably marked near-term tops in the 10Y US bond future (i.e., lows in long-term bond yields). And today, our Fast Money indicator - a measure of speculative activity - also triggered a sell signal on the 10-year UST bond future.

Taken together, we think there are two effective hedges for credit exposure. First, betting on more Fed rate cuts (e.g., via long March 2026 SOFR) as a hedge for downside growth risks. Second, betting on higher long-term bond yields (e.g., via TLT puts) given the sharp fall in the MOVE index. 

Clients can see all of our key charts on credit in our Chart Collection.