The Big Idea
The rising dispersion of credit spreads
This material is a Marketing Communication and does not constitute Independent Investment Research.
Debt markets rarely have drawn such sharp lines between credits as they do now. Spreads in technology and communications have jumped to some of their widest levels in five years, while spreads in energy, utilities, health care, industrials, materials and consumer staples have moved almost as sharply the other way. As a result, the gap in spreads across sectors is the widest in five years. It will likely grow until Fed policy, corporate results or both rein it in.
Credit spreads take very different paths
Spreads across credit sectors have taken sharply different paths in the past year (Exhibit 1A). Each sector tends to trade at a typical spread to the overall investment grade index. Bank and insurer debt, for instance, usually trades wide. So it helps to convert each sector’s spread into a standardized score, or z-score, relative to the index. Those scores show dispersion rising steadily. A year ago, every investment grade sector traded within one standard deviation of its average spread to the index. Today, some sectors trade about three standard deviations wide and others three standard deviations tight. Dispersion has gone from one of its lowest levels in five years to its highest (Exhibit 1B).
Exhibit 1A: Sector spreads have taken sharply different paths in the past year
Note: Data shows each sector’s standardized OAS to the Bloomberg investment grade corporate index. Each sector’s spread to the index is converted to the number of standard deviations from its five-year average: (Current sector OAS spread to the index – Average sector OAS spread to the index)/(Standard deviation of OAS spread to the index).
Source: Bloomberg, Santander US Capital Markets.
Exhibit 1B: Spread dispersion hits a five-year high
Note: Data shows the difference between the highest and lowest standardized sector spreads to the index OAS.
Source: Bloomberg, Santander US Capital Markets
The dispersion reflects clear differences in risk. A few examples:
- Technology has faced a flood of new debt and worries that heavy capital spending will drain free cash flow and add leverage, pushing spreads to 2.97 standard deviations above average
- Communications spreads have widened on Meta’s heavy capital spending and, more recently, on weaker-than-expected earnings at Charter Communications, reaching90 standard deviations above average
- Energy has moved the other way as the US-Iran war has kept prices near five-year highs, tightening spreads to 3.45 standard deviations below average
- The AI buildout may have hurt technology debt overall, but it has boosted demand for electricity and water, helping tighten utility spreads to 2.50 standard deviations below average
- Materials companies have ridden rising prices to spreads 2.10 standard deviations below average
- And investors diversifying away from technology, along with a generally strong economy, have arguably helped tighten spreads in industrials, health care and consumer staples to 0 to 1.5 standard deviations below average
Dispersion or reversion
As long as heavy tech capital spending continues, spread dispersion across credit will likely hold or widen. Recent earnings calls from the largest tech companies—Alphabet, Amazon, Meta, Microsoft, Oracle and SpaceX—suggest capital spending could climb from $863 billion this year to $1.33 trillion next year. That should push tech debt spreads even wider. The same spending should help tighten spreads in utilities and in sectors investors use to diversify away from tech. A generally strong economy should support spreads in industrials and consumer staples.
On the other hand, Fed efforts to fight inflation could pull spreads back together. Even if higher rates fail to rein in tech spending, they should cool more traditional sectors and slow spread tightening outside of technology. The most rate-sensitive sectors could even widen, narrowing dispersion from the tight end.
Weak tech results could also narrow spread gaps. Lower revenue or falling free cash flow at the big AI builders might raise fundamental risk, but it could also slow capital spending and ease supply pressure on credit markets. Utilities and other sectors lifted by that spending could give back some gains, and dispersion could narrow.
For now, it’s hard to add tech exposure while AI builders keep signaling they’ll need even more funding in 2027 and as the Fed takes a measured approach to bringing down inflation. Dispersion will likely hold or rise. At the very least, it makes sense to wait until the Fed starts tapping the brakes on the economy. That may be the time to position for credit spreads to converge.
* * *
The view in rates
The market is pricing another 18 bp of Fed tightening by December and then 36 bp more—for a total of 54 bp—before the end of 2027.
A break in the AI rally could hit credit and the broader economy and lead recession to drag rates lower, but that possibility looks remote. CoreWeave has shown some vulnerability, so highly leveraged balance sheets should be the place to look for AI weakness. However, the AI build among hyperscalers seems almost immune to higher rates for now.
Apart from the AI rally, the market is clearly concerned about the impact of higher rates on other parts of the economy—housing, automotive, other rate-sensitive sectors. The question is the level of rates where those sectors start to noticeably slow.
Key market levels:
- Three-month term SOFR traded late this week at 406 bp, unchanged in two weeks.
- The 2-year Treasury note traded Friday at 4.59%, down 17 bp in two weeks. The 10-year note traded at 4.93%, down 16 bp in two weeks.
- The Treasury yield flattened sharply in the last two weeks, with 2s10s at 34 bp, steeper by 1 bp. The 5s30s traded late in the week at 59 bp, steeper by 7 bp in the last two weeks.
- The 10-year inflation breakeven traded Friday at 234 bp, up 1 bp in two weeks. The 5-year, 5-year forward breakeven was 221 bp, down 7 bp. The 10-year real rate ended the week at 259 bp, down 18 bp.
The view in spreads
Risk spreads are moving in very different directions with credit broadly wider—with wide dispersion across sectors—and MBS tighter. The Bloomberg US investment-grade corporate bond index option-adjusted spread traded late in the week at 87 bp, wider by 4 bp in the last two weeks. Nominal par 30-year MBS spreads to a blend of 5- and 10-year Treasury yields were 125 bp, wider by 2 bp. Par 30-year MBS Treasury option-adjusted spreads closed at 32 bp, tighter by 3 bp in the last two weeks.
The view in credit
Persistent high rates should put pressure on more leveraged balance sheets. Large companies have healthier balance sheets than smaller ones. Middle- and higher-income consumers also carry relatively little debt and have strong liquidity and wealth.
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