KBRA Financial Intelligence

3 Things in Credit: Credit Scarcity, Debt and Deficits, and Markets' Round Trip

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

A headline in The New York Times caught my eye this week: “Faith and Credit: We try to demystify the bond market.” Well, I’ve been trying to do that for decades. So, I’m all ears. Demystify away!

The author keeps things at a basic level: “Bonds are basically IOUs” And he oddly admits halfway through his demystifying exercise that much about bonds he finds, well, mystifying. “The market for these bonds is opaque. Descriptions of it can sound as if someone is reading the glossary of an economics textbook.” Ugh. Through it all, bond value depends on trust, something that is largely about—you ready for this? “Feelings.” True story. And you won’t find that in any economics textbook. But you will find it here, in 3 Things. We’re all about feelings.

This week, our 3 Things are:

1. Credit scarcity. Too much money chasing too few bonds?

2. Debt and deficits. Ignore at your own peril.

3. Markets’ round trip. Knowing what we know, and what we don’t—does that make sense?

Alright, let’s dig a bit deeper.

Credit scarcity.

We saw a discussion this week with Russell Brownback, head of macro positioning at BlackRock, which we found quite interesting. His insights into just how powerful the technicals are in credit, including supply and demand, help to explain why spreads remain historically tight.

When asked about why spreads are so tight, he cites three reasons (you know I like things in three):

• Credit quality is pristine

  : In investment-grade down to BBs, fundamentals are sound. We would agree. Corporate balance sheets (especially among larger firms) are in good shape, and margins are just off of 50-year highs. High-yield default rates are low, reflecting a mix shift resulting in a higher quality skew. Even lower-quality credit (single B and worse) has benefited from the strong economy and abundant liquidity.

• Investors don’t buy spreads, they buy yields

  : We agree. It’s a mantra of ours. And the demand for yields that are holding at or around the highest levels in 15 years, accentuates the attributes—income and diversification—that draw investors to fixed income in the first place.

• Strong technicals

  : Twenty years ago, Mr. Brownback says, the U.S. Treasury market and the IG credit market were roughly the same size. Today, IG is half the size of the Treasury market (thanks largely to the policy decisions to solve two crises, the GFC and COVID, with government-issued debt). Mr. Brownback suggests it all adds up to a relative scarcity with regard to investable credit. Not enough supply and lots of demand will drive spreads tighter.

How durable is this trifecta? Well, if we accept our growth forecast calling for a deceleration in 2025 to 1%, credit will be less pristine. But with a wall of liquidity out there and the strong shape that corporates are in heading into slowdown, especially larger corporates, credit quality is likely to remain strong.

With regard to yields, we are settling into a range where the risk-free rate has returned to a more normal range while spreads on our less pristine but still strong credit edge higher. The combination is an attractive alternative to lower yielding cash and frothy stocks.

And those technicals of too much money chasing too few credit assets aren’t changing anytime soon, provided we steer clear of a prolonged and deep recession.

Alright, on to our second Thing—Debt and deficits.

As the “Big, Beautiful Bill” moves through Congress this summer, there are a number of questions that hang over its development. Will it be stimulative? Will there be a legislative pushback against the House of Representative’s bill and the increased deficit that would result? Will the bond market push back? Credit investors should care about all of these things. Do legislators?

You can make a case that they don’t. The IMF found in a 2010 study that legislators are more sensitive to rising deficits at low levels of debt than they are at high levels. A recent Brookings paper suggests a similar phenomenon. It found that Congress did act to reduce the deficit during the period from 1984-2003, but it has not responded in the past 20 years, as the deficit skyrocketed. Somewhat alarmingly, this is intuitive. At some point, the problem becomes so overwhelming that you give up and accept it. And when coupled with the fact that democracies are built on favors delivered to constituents, deficit spending becomes the norm. Sure, you could take a moral stand against the deficit as the few remaining budget hawks in Congress do, but you would do so at your own risk of reelection.

Alright, so the deficit has grown. Our growing deficit occurred right alongside the rise of U.S. exceptionalism. Can’t the two coexist?

In the post-GFC years, marked by low growth and slow-to-reduce high levels of unemployment, zero interest rate policy gave rise to the idea that as long as the real interest rate is lower than the economic growth rate (as was the case), output exceeds the cost of servicing debt, resulting in a decline in the debt-to-GDP ratio.

So, what’s the fuss? The fuss is inflation. To deal with the price stability as part of its dual mandate, the Fed eventually has to hike rates. Real rates returning toward normal ushers in new concern over the cost of debt service. Today, the Treasury will spend more on debt service than on defense, Medicaid, or Medicare.

Now think about some of the newly introduced risks to the equation. Recession. Reignited inflation (or both). Foreign investors “rebalancing,” i.e., selling U.S. assets. That makes the deficit worse.

Some would push back, saying either that accelerating growth will cure the deficit or citing Japan’s experience where it has carried a much larger government debt burden for decades. I’m not sure credit investors can be comforted by either.

Alright, on to our third Thing—Markets’ round-trip.

One of our pet peeves is when folks say all is well by citing Q1 earnings. Yes, earnings of the S&P 500 (96% reporting) grew a whopping 13% year-over-year in the most recent period, double what was forecast, with roughly the usual percentage of positive surprises (77%) and year-over-year increases (67%).

Our problem is that these reports are all in the rearview mirror, and no doubt had some pull-forward of activity ahead of tariffs. It really wasn’t until the second quarter where the operating landscape has been subject to the shock of uncertainty. None of that is any great revelation at this stage, but the old adage that “past performance is not indicative of future results” would seem to apply, right? Think about the headwinds for a moment:

• We are in the midst of a tax hike via tariffs of a magnitude that figures to cut GDP growth in half (by the way, we assume what will result in the end is a 10% universal tariff, along with select additional levies on certain industries and countries that bring the effective tariff rate to 15%).

• Tariffs remain fluid, an easily grabbed tool in the toolkit to be imposed or paused at will. Planning for businesses has not gotten any easier. Consider Apple’s experience.

• Monetary policy remains restrictive. The Fed would like to cut rates, but it can’t because of the inflation threat related to tariffs.

So, taking all of that into consideration, earnings estimates should fall, right? And they have. The consensus estimate for Q2 is (ready for this?) 3%. Over the past year, that estimate has fallen from 15% to 3%. And that’s from equity analysts that typically are optimistic by nature. Q3 is forecast to be a bit better at 7%, Q4 at 6%.

Yet risk premia in credit are back toward the extremely low levels prior to the election: IG within 8 bps, having tightened 30 bps from the April wide, and HY within 38 bps, having tightened 137 bps since its April wide.

Our issue from a valuation perspective is that we are, once again, priced nearly for perfection when we are facing a data vacuum, but where we have a pretty good hunch that risk has gone materially higher. Questions abound. We don’t know the impact of tariffs. We don’t know if inflation will reverse course and move further away from target. We don’t know how demand from foreign investors in U.S. corporate bonds (that’s 25% of the total buyer base) will behave. We don’t know how the risk-free rate will behave.

Bulls will suggest that the Big, Beautiful Bill will be stimulative, that a wave of deregulation is about to be unleashed, and that we are on the verge of another productivity revolution courtesy of AI. Those may be true. But, on balance, over the near term, we think the magnitude and certainty of the risks outweigh the benefits.

So, there you have it, 3 Things in Credit:

1. Credit scarcity. A compelling argument for tight spreads.

2. Debt and deficits. The risk to rates is a threat to credit performance.

3. Markets’ round trip. We’re in a data vacuum. Q1 earnings are less relevant and tariffs’ lagged effects are waiting in the wings.

As always, thanks for joining. We’ll see you next week.