Credit as a haven from the bond vigilantes

Bond vigilantes is a pithy way to describe a major sovereign bond selloff. During the great economic moderation that followed the inflation shocks of the early 1980s, bond vigilantes were seldom seen outside troubled economies. That changed during the post-Covid inflationary surge. Now, with the vigilantes increasingly concerned about fiscal deficits across developed economies – notably in the US and Europe - they are once again casting a shadow over sovereign debt markets.

Fortunately for fixed income investors, there’s a corner of the market that offers a margin of safety from the risks that are piling up the sovereign debt markets: credit. On the face of it, this is counter-intuitive. Sovereign debt – at least in developed markets – is meant to represent the risk free rate against which other fixed income instruments are priced. Credit has historically been seen as exposed to default risk.

History doesn’t bear this out, however.  Since 1980, defaults on investment grade credit have been less than 0.1%. In essence, that’s virtually zero, making it more or less the same as default risk on developed economy sovereign debt. 

And yet, investment grade credit offers a premium yield to sovereigns (see Fig. 1). This premium on US investment grade credit over US Treasury bonds has averaged a little under 149 basis points since 2015. And even now, with a significant compression of these spreads, the premium is still 83 basis points. In other words, investors are being paid extra for taking essentially the same amount of risk.

This premium represents a buffer. At a time when government deficits have risen to dangerous levels and continue to climb¹, investors are growing nervous. Research shows that bad news about government finances pushes up sovereign bond yields even in US Treasuries, the world’s most liquid bond market.²

It doesn’t necessarily follow that if bond investors take fright at a sovereign debt market the country’s investment grade credits will follow suit. In emerging markets, yields on bonds issued by high quality corporates frequently trade below the home country’s sovereign yield. That makes sense. Companies with global operations and therefore widespread sources of hard currency revenue will often find it easier to service their debts than, for instance, countries dependent on exports of a single commodity.

But it doesn’t just happen in emerging markets. In France, yields on debt issued by pharmaceutical company Sanofi and consumer goods firm L’Oreal, for example, have both recently fallen below yields on French government bond with the same maturity.

And while credit market valuation is on the rich side, corporate earnings are still strong while company balance sheets are healthy, whereas government finances are looking vulnerable. For instance, issuance has been far more moderate than that of sovereign debt (see Fig. 2). Investors are less focused on spreads than they were when sovereign yields were near zero, and are taking comfort in overall yields. Credit is in vogue because the all-in yield is attractive.

And while it’s true that, ultimately, when push comes to shove and national governments need money, they can tax businesses, we also know that corporations are adept at shifting their business to lower tax jurisdictions. Governments who tax hard run the risk of hurting their overall tax take, especially if it depresses domestic economic activity generally.

Credit investors will have taken comfort in how resilient their market has been even during recent shocks that have roiled equities, like the Nvidia-driven selloff of Nasdaq stocks and the wobble caused by Donald Trump’s recent tariff announcement. Once again, that’s been down to robust earnings streams and balance sheets (see Fig. 3). Growth in corporate borrowing has largely tracked earnings growth, and, crucially, free cash flow, during recent decades, ensuring that companies are able to service their debt from income. By contrast, sovereign debt has rapidly outpaced GDP growth.

Nor is this state of health restricted to investment grade credits. Low default rates in high yield – though they’re ticking up somewhat – have also drawn investors, pushing down spreads in that part of the market.

There is always the risk of black swans – impossible to anticipate events – that can shred even the most solid markets. Catastrophes can hit from various directions. But short of these credit offers a yield uplift on sovereign bonds with, in the case of investment grade, equivalent riskiness, making them a relative safe harbour when turmoil of governments’ own making threatens their bonds.