The market euphoria has no limits. Even sophisticated bond investors show no fear

The risk premium investors demand when purchasing corporate bonds has tumbled to its lowest level in nearly two decades, as sophisticated fixed-income buyers show no fear despite an incredibly uncertain world.

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In 2024, corporate debt issuance in Canada and the United States roared back to pandemic-era levels. In June, Coastal GasLink completed a $7.15-billion refinancing of its construction debt, marking the largest corporate bond offering in Canadian history. Just last week, Equitable Bank issued a $500-million fixed rate deposit note offering, its third this year, and the deal was nearly three-times oversubscribed.

Even more telling, investors have been willing to pay premium prices for the debt. Equitable issued its bonds in two tranches – in short, at two different maturity dates – and one tranche was priced at the company’s lowest-ever spread to government debt.

Unlike stocks, where investor appetite can be measured with metrics such as the price-to-earnings ratio, debt investors show their willingness to buy corporate bonds through the interest rate, or yield, premium they demand over and above government bonds.

Because government debt in Canada and the U.S. is considered ultrasafe, interest rates on these bonds are used as benchmarks. If a 10-year government bond pays 1 per cent in annual interest, a 10-year corporate bond may charge 3 per cent. The two-percentage-point difference, known as the spread, is the compensation that investors demand for the greater chance that the company will go bankrupt.

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This premium is now ultralow for companies of all sizes and risk levels – and has been most of the year.

Fixed-income markets are “remarkably sanguine given the geopolitical risks,” wrote Nicole Serino and Christian Esters, credit analysts at debt rating agency S&P Global Ratings, in a research note to clients this month. Examples of these risks include chaos in the Middle East, a weak Chinese economy, the potential for global trade tariffs and uncertainty over the Russia-Ukraine war.

For investment grade corporate bonds in the U.S., which are bonds issued by blue chip companies, the average spread over government debt is currently around 80 basis points, or 0.8 percentage points, according to the ICE BofA US Corporate Index spread. That’s a 19-year low.

The same is true for U.S. high yield debt, or bonds issued by companies with “junk” debt ratings that have lower chances paying the money back. For these bonds, the average spread is around 2.7 percentage points, far below the 4.9 percentage points average over the past two decades, according to the Bloomberg U.S. Corporate High Yield Index.

The historically-low premiums prove recent investor euphoria isn’t isolated to markets that attract retail buyers.

As equity markets in Canada and the U.S. soared throughout 2024, some pessimists argued the gains were heavily influenced by retail investors who treat stocks more like gambling bets than as long-term investments. In other words, so-called “dumb money” helped fuel the markets to record highs.

Debt markets, though, have little retail participation, and they, too, are soaring.

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Institutional investors are finding comfort in strong economic fundamentals, particularly in the United States. In a report Friday, BMO economist Sal Guatieri said that “easing monetary policy, rising wealth, and sturdy income growth have laid a solid foundation for U.S. consumers” – which helps explain why the U.S. economy keeps dominating.

Yet his own colleague, chief economist Doug Porter, said that so much has to be ignored in order to stay Zen. The Federal Reserve suggested this week that interest rates may not come down as quickly as expected because inflation has been sticky, and “beyond the Fed, markets are also dealing with profound policy uncertainty in general,” he wrote in a note to clients.

Some examples: the recent threat of a U.S. government shutdown, plans to trim the US$2-trillion budget deficit and a promised effort to rein in government spending, which could boost unemployment.

Amid the uncertainty, some analysts have noted historical parallels for the current credit spreads. The past two times they were this low for substantial periods of time was the mid-1990s and 2007. In the first instance, the dot-com crash unfolded within a few years. In the second, the 2008 global financial crisis ultimately erupted.

For those betting on another sharp correction, it could take years to play out.

“The episode that perhaps resembles the current situation best is the mid-1990s where investment grade spreads stayed below 100 basis points for more than four years,” a team of credit strategists at Goldman Sachs wrote in a recent note to clients.

“If the current episode, which is 9-10 months old, ends up resembling the mid-90s, spreads could remain in their current neighbourhood for many more quarters.”