Whenever equities are trending in a particular direction, we like to track the high yield credit markets in order to get a confirmation of the trend. High yield spreads measure the difference in yield between junk rated bonds and treasuries of comparable maturity. When spreads are rising it indicates that investors are demanding more yield in order to take on the added risk of the issuers, while falling spreads indicate that investors are comfortable taking on the added risk.
A look at the current level of spreads indicates that investors are increasingly comfortable with the high yield market. The chart below shows high yield credit spreads based on the Bank of America Merrill Lynch High Yield Master Index going back to 1997. At a current reading of 411 basis points (bps) over treasuries, spreads are at their lowest level in more than six years (October 2007)!
With high yield spreads at their lowest levels since October 2007, skeptics will argue that the last time spreads were at these levels marked the peak of the bull market. There's no denying that, but we would note that in October 2007, spreads had already been at comparably low levels for more than three and a half years before the bear market started. Additionally, back in the late 1990s we also saw a prolonged period where spreads were at comparably low levels before the market began to falter.
Another reason why the low level of spreads is of little concern is because default rates are also at historically low levels. According to Moody's, the default rate for junk rated American companies dropped to 2.4% in November, which according to Barron's, "is barely more than half its long-term historic average and down from 3.1% a year ago."