Credit spreads keep ratcheting down as the bull market in credit continues. Bull markets typically have three legs. The first is what I call disbelief, which is what we went through in March 2009. This is when assets are so depressed from widespread liquidation that when selling pressure eases, prices rise. The next leg is the fundamental leg when improving fundamentals, such as falling default rates and lower inflation, drive the appreciation in prices. The third leg is a period of overvaluation. This stage often runs further and lasts longer than investors expect.
The high yield bond market appears to be moving from the fundamental leg to the overvalued leg. A greater portion of investment activity in the high yield market is now based on investors simply wanting to own the asset class. As a result, it has become harder to find the same level of value previously experienced in the below-investment grade market. While there is still a fair amount of room for spreads to tighten further, investors should be aware of the shift in the environment and adjust investment decisions accordingly.