KBRA Financial Intelligence

3 Things in Credit: Spreads vs. Yields, Financial Conditions, and Walmart/Target Read-Across

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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.

Howard Marks is out with his latest memo, and it hits at the point we make below, that the current returns on credit compare favorably to what figures to lie ahead in stocks. Mr. Marks observes that we are in “early days” of equity market exuberance, even while pointing out that we haven’t had a correction in 16 years. He points out that current investment grade yields in the “6’s,” as in 6+%, compares well on a risk-adjusted basis to what could be expected in stocks. To that point, we think of the research piece David Kostin and crew at Goldman Sachs published last October forecasting annualized nominal returns of the S&P 500 over the next 10 years to be … you ready for this? 3%. That math I understand.

This week, our 3 Things are:

1. Spreads vs. yields. Spreads are tight. Yields, not so much.

2. Financial conditions. Don’t lose sight of what normal is.

3. Walmart/Target read-across. The big boxes update us on the U.S. consumer.

Alright, let’s dig a bit deeper.

Spreads vs. yields.

Spreads are tight. How tight? Tightest in 27 years, according to Bloomberg. In other words, the risk premium on investment-grade credit spreads is extremely, historically, low. Does that make sense? To repeat what has become a mantra over here, credit risk is priced for perfection in an imperfect world.

We are also fond of saying, investors don’t buy credit spreads; they buy yields. Yields, of course, are made up of the risk-free rate and the risk premium. Now we’re getting somewhere.

The investment-grade yield currently sits at 4.95%; that’s nowhere near the 27-year low of 1.74% hit in December 2020 in the midst of COVID. In fact, the current yield lies in the 55th percentile of yields over that 27-year period, or some 30 bps above the average. That’s hardly extreme.

Let’s go back to the equation, risk-free rate plus the risk premium. Maybe we should focus on the risk-free rate. The 10-year U.S. Treasury yield, 4.34%, is 93 bps above its 27-year average of 3.41%. Maybe that’s the issue.

Peeling that onion, recall that the U.S. has used federal debt to address its two most recent crises, the GFC and COVID. That has pushed federal debt held by the public to GDP up to 100% from 35% prior to the GFC. Meanwhile, private sector debt to GDP has fallen from 171% in 2008 to 143% at year-end 2024. In other words, we’ve basically transferred leverage in the private sector to the public sector. With that comes a cost to the risk-free rate. So, pulling it all together, we see investment-grade credit yields that are attractive enough to draw plenty of investor interest on their own, and even more so when compared to equities where valuations are not only extreme, but more vulnerable to correction than credit. That is, as long as bond vigilantes continue to accept the U.S. debt and deficit story.

Alright, on to our second Thing—Financial conditions.

Financial conditions are variably defined as conditions across financial markets that can affect the dynamics of the economy (San Francisco Fed), how easily money and credit flow through the economy (IMF), and the availability and cost of financing for real economic activity (Bank for International Settlements). There are a variety of indices—Bloomberg, the New York and Chicago Feds, and Goldman Sachs to name a few—that track how favorable financial conditions are.

Not surprisingly, those indices suggest that financial conditions are quite favorable today, having improved steadily from the inflation scare of 2022. Spreads are super tight, money markets are humming right along, and equity multiples, broadly speaking, are buoyant to say the least.

Another index, the St. Louis Fed Financial Stress Index, measures market stress as opposed to ease/tightness of financing, and that is quite benign.

Yet one market observer we saw this week wondered, if financial conditions are so favorable, why is the housing market so weak, and why is the Fed’s senior loan officer survey tightening? Those are reasonable questions that require a bit of perspective.

Favorable financial conditions speak to financing, particularly credit, being widely available at a reasonable price. Let’s take those components one at a time.

The housing market is weak because there is not enough supply, and scarcity has significantly reduced affordability. Mortgage rates are not the problem. In the 20 years prior to the GFC (removing the post-GFC QE years), the average mortgage rate was 7.3%; today it’s 6.7%. The problem in the housing market is homebuilder confidence, which stems in part from cost and availability of labor and materials. It’s not mortgage rates.

What about bank lending—why is the senior loan officer survey index tightening? While that’s true, it is tightening, it is tightening back to zero, which means as many banks are loosening credit as those that are tightening. There is not a tightening skew, as is the case when credit is crunching. Banks, and other lenders are being more cautious, as you would expect in an environment of policy uncertainty and economic slowdown. All of that is normal in a normal economic environment.

The point is, financing is widely available today from a variety of sources at a cost that reflects normalized risk, not subsidized risk. Sure, lenders are more selective today because the economy is slowing and uncertainty—on rates, on policy, and on the macro landscape—has risen. Overall, however, financial conditions, as reflected in the various indices and in the real economy are favorable. Not perfect. Favorable.

Alright, on to our third Thing—Walmart/Target read-across.

We always look to earnings color from the two big box retailers for insight into the health of the U.S. consumer. While this week’s quarterly update is noteworthy mostly as a result of management change at beleaguered Target, we still got useful context from both on the most economically vulnerable cohort of U.S. consumers, middle to lower income earning households.

At Target, management referred to the macro environment as “challenging,” as they look to navigate inflation and heightened uncertainty around tariffs. Accordingly, finding value is “very top-of-mind for consumers right now. They're looking to stretch their budget.” Management added that the consumer has to be more “choiceful,” which leads to a pullback in some of the discretionary categories and their discretionary spending. From our perspective, that adds up to softening consumer spending.

Similar themes are expressed by Walmart, although, like Target, management set a tone of dampening any drama around changing consumer behavior. Walmart said, “As it relates to what we're experiencing with customers … here in the U.S., their behavior's been generally consistent. We aren't seeing dramatic shifts. The way things have played out so far, the impact of tariffs has been gradual enough that any behavioral adjustments by the customer have been somewhat muted.”

Management added, “Not surprisingly, we see more adjustments in middle and lower income households than we do with higher income households. In discretionary categories where item prices have gone up, we see a corresponding moderation in units at the item level as customers switch to other items or, in some cases, categories.” So, a common thread running through the big-box retailers of customers being more “choiceful” (to use the sector’s word-of-the-year), with plenty evidence of trading down as a strategy. It points to spending slowdown, but nowhere near a shock.

Walmart did add that the impact of tariffs is building, consistent with our view that it will be Q4 into Q1 2026 when we get a more complete look at what the full impact of tariffs will be. In management’s words: “As we replenish inventory at post-tariff price levels, we've continued to see our costs increase each week, which we expect will continue into the third and fourth quarters.” Still, not to overdo the concern, management pointed to a reasonably healthy back-to-school season, which typically bodes well for the holiday season. “We're expecting to have a good holiday season at Walmart.”

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

1. Spreads vs. yields. Investors buy yields, not spreads.

2. Financial conditions. Financing markets are wide open, just not at subsidized prices.

3. Walmart/Target read across. More “choiceful” consumers dampen consumer spending growth expectations.

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