Challenges to the resilience of US corporate bond spreads

Prepared by Mar Domenech Palacios and Martina Jančoková

Published as part of the ECB Economic Bulletin, Issue 3/2025.

Prior to the recent abrupt widening, US corporate bond spreads experienced a prolonged phase of unusual resilience, despite a backdrop of elevated interest rates. Throughout 2024, the risk premium required by investors to hold US corporate debt over government securities – as measured by non-financial corporate bond spreads – remained remarkably compressed. Investment-grade corporate bond spreads ranged between 83 and 112 basis points, while high-yield spreads fluctuated between 264 and 393 basis points. Spreads stood at their lowest levels in nearly two decades, falling within the first quintile of the historical spread distribution since 1999 (see Chart A). However, more recently, US corporate spreads have widened significantly, increasing to 120 basis points for investment-grade and 461 basis points for high-yield bonds. This abrupt shift has coincided with the announcement of new tariffs by the US administration, which has triggered a sharp deterioration in market risk sentiment. Against this backdrop, and in light of the recent market repricing, this box examines the factors that contributed to the previous resilience of US corporate bond spreads and assesses the potential risks of spread decompression in the period ahead.

Until recently, and beyond strong firm fundamentals, a pronounced risk-on sentiment in global financial markets supported robust demand for US corporate bonds, explaining a large proportion of the compression in spreads. Strong realised earnings and strong expected earnings, driven in part by expected artificial intelligence (AI)-related productivity gains, supported US equity prices and compressed spreads in US corporate bond markets.^[1] Estimates of the excess bond premium (EBP), which reflects the additional compensation investors require for holding corporate bonds beyond what is justified by fundamentals, such as default risk, pointed to persistently strong risk appetite since the end of 2022 (Chart B, panel a).^[2] The compression was also broad-based: until the end of February 2025, nearly 90% of bonds in the sample were trading below the levels implied by firm-specific fundamentals. Similar dynamics have been observed in past tightening cycles, with the EBP reaching comparable or even lower levels during the 1993-1995 and 2004-2006 periods.^[3] Model analysis suggests that corporate bond spreads tend to respond less to macroeconomic and monetary policy shocks during these risk-on phases than during risk-off periods (Chart B, panel b). This may explain the muted reaction of spreads to such shocks while risk sentiment remained buoyant. However, more recent events have seen a rapid reversal of this positive sentiment. Corporate bond spreads have widened markedly, signalling a notable repricing of risk. As a result, the market appears increasingly sensitive to macroeconomic and policy developments, raising the risk of heightened volatility and a stronger response to future shocks as sentiment continues to adjust.

The composition of US corporate bond issuance among high-yield issuers, which shifted towards higher-quality bonds, also supported the aggregate compression in spreads. Since 2007, the proportion of BB-rated bonds among new issuances in the high-yield category has been increasing, while the issuance of riskier B-rated bonds has been declining, and the issuance of bonds rated CCC or below has remained relatively low and has been particularly low in the last two years (Chart C). At the same time, the number of downgrades and upgrades of corporate bonds has been relatively balanced. The trend towards less risky high-yield bonds might also reflect relatively robust corporate balance sheets and profitability in recent years and may have contributed to the overall lower spreads.

Two types of risk are present – debt rollover risk and repricing risk. A substantial amount of US corporate debt will potentially need to be refinanced in the coming months and years. This includes USD 642 billion of debt scheduled to mature in the rest of 2025, USD 930 billion in 2026 and USD 860 billion in 2027. Despite recent policy rate cuts by the Federal Reserve, corporate funding costs remain elevated, as interest rates are still generally higher than those prevailing at the time of issuance, exposing US firms to higher costs when refinancing their debt. Simulations suggest that 85% of the maturing debt would need to be refinanced at higher rates. More than half of maturing bonds would face more than a 1 percentage point increase in interest rates if refinanced at current rates, while around 25% of maturing bonds would face more than a 2 percentage point increase (Chart D). Such increases in costs could potentially weaken firm fundamentals, raising default risks and worsening risk sentiment.^[4]

A deterioration in risk sentiment triggers heightened bond sensitivity and a disproportionate spread widening for more vulnerable firms. The recent abrupt shift in risk sentiment could carry significant implications, not only altering the average magnitude of reactions to market shocks but also influencing which bonds are most responsive. During risk-off episodes, bonds exhibit heightened sensitivity, reacting more intensely to market dynamics (Chart B, panel b). Moreover, analysis reveals that, in these periods, investors tend to retreat from bonds issued by firms with worse financing conditions given their fundamentals (bonds in the right tail of the EBP distribution), causing a disproportionate widening of their spreads. While firm fundamentals remain strong, corporate expected default frequencies (EDFs), which indicate the probability that a company will default on its payments within one year, point to limited but emerging vulnerabilities. For example, the 75th percentile of EDFs has been on a strong upward trend and at the end of March 2025 stood at around 18%, a level not observed since the global financial crisis (Chart E).