Corporate bonds in 2025: tighter spreads ahead?

Credit spreads today are a long way from generous; corporate bonds are not ‘cheap.’ Historically, spreads in the sterling investment-grade market have, excepting brief periods of crisis, hovered in a broad trading range between 200 basis points (bps) and 100 bps. Today, they stand at around 110 bps¹. So you might argue that there’s little room left for them to tighten any further.

Spreads could tighten even further in 2025

At the same time, however, conditions have changed over the last two decades: some parts of the private sector have de-levered even as governments have pushed sovereign debt burdens to levels previously only seen in wartime. That might suggest that the calculations investors need to make when looking at corporate bonds may need to change too: spreads could get even tighter in 2025.

Spreads are towards the low end of their post financial crisis trading range 

To recap, the all-in yield on a corporate bond consists of the ‘risk free’ yield on the underlying government bond plus the spread, which compensates creditors for the incremental risk of default. And while the risks associated with lending to corporates have fallen, it could be argued that the risk of lending to governments has increased.

Since the financial crisis, government balance sheets across the West have weakened. In 2007, the UK had a pretty strong balance sheet, with a debt-to-GDP ratio of around 40%. Then came the financial crisis. And then came Covid. Today, the UK’s debt-to-GDP ratio stands at about 100%². So, the ‘risk free’ bit – the underlying government bond yield – is not quite as ‘risk free’ as it once was. At the same time, credit as an asset class appears to have become less risky.

Corporate bonds are arguably less risky than they once were

Getting hold of good data is hard, but it seems that many UK corporates have de-levered over the last 20 years³. So even though interest rates shot up in 2022-23, that isn't a problem for the majority of corporate borrowers. One of the consequences of the long era of QE and zero interest rates was that almost any large investment-grade company could have issued a bond just a few years back with a coupon of 2% or less.

Those borrowing costs have been locked in for the medium-to-long term and companies today are spending modest sums on servicing their debts. Debt service ratios are substantially lower than they were before the financial crisis.

Debt service ratios for UK non-financial corporations have moved significantly lower over the past 20 years 

Given that, where should credit spreads be today? And where will they go next? I'm not arguing that credit spreads are about to return to the extremely tight levels we saw immediately prior to the financial crisis. And I’m nervous of suggesting that we should apply a new valuation paradigm; I'm old enough to remember some of the dubious valuation metrics (price per click, anyone?) that brokers once used to justify the bubble in internet stocks. But I am suggesting that some of the market’s preconceptions about whether spreads can tighten any further may need to be revisited.

Why tighter spreads on investment-grade bonds could be a ‘pain trade’ in 2025

The technical set-up seems simple. Because all-in yields are so attractive, bond funds are seeing inflows. At the same time, there is little fresh supply. Companies have no pressing need to return to the market to borrow more – so there simply isn’t a lot of supply in the pipeline. Something must give and, to my mind, credit spreads are the most likely candidate. Spreads deserve to be tight – and the technical setup suggests that they could potentially become even tighter than they are today. For investors without a meaningful allocation to corporate bonds, the ‘pain trade’ in 2025 would be for credit spreads to tighten. I’m not arguing that this is certain to happen – but I am suggesting that it might.