By Randall W. Forsyth

You can't call them junk bonds anymore. Sub-investment-grade corporate debt securities have come up in the world with higher credit quality to such an extent that their preferred moniker, high-yield, scarcely fits. So investors looking for richer returns have migrated to riskier environs, especially the trendiest one, private credit.

That doesn't mean credit risk has disappeared, however. It has just become less visible in the private market, where credits don't trade and prices aren't posted on quote screens.

Private credit describes what banks used to dominate -- bespoke loans made to typically smaller, growing businesses. High-yield bonds also have matured from the era of the 1980s, when Drexel Burnham Lambert pioneered new issues of sub-investment-grade bonds to fund growing companies that previously were shut out by the incumbent Wall Street banks. It seems no coincidence that Drexel alums dominate the current credit powerhouses, such as Apollo Global Management, Blackstone, Jefferies Financial Group, and Ares Management, among others, that are leading the surge in private credit.

The high-yield market has gotten safer as private-credit markets have expanded the pool of risky borrowers, Greg Obenshain, director of credit at Verdad, wrote in a client note. Much of the riskiest borrowing, from issuers whose credit would be rated CCC or B, has moved to private credit and leveraged loans, he added in an interview.

Private credit has grown to $2.5 trillion globally from just about $200 million in the early 2000s, according to the Bank for International Settlements quarterly review published a couple of weeks ago. Meanwhile, the Bloomberg High-Yield Index totals about $1.4 trillion of debt, while the public leveraged-loan market totals $1.3 trillion, according to Fitch data. In recent years, the high-yield bond market has increased glacially, by 0.44% annually since 2015, compared with 11.4% compounded annually from 1986 to 2014, according to Martin Fridson, chief investment officer of Lehmann Livian Fridson Advisors.

The private market can provide more complicated financing that is "more hand-carved than machine-made," Craig Manchuck, portfolio manager of the Osterweis Strategic Income fund, said in an interview. Banks did more of such highly levered transactions in the past but have been restricted by regulatory curbs. Plus, some of them have a bitter taste from loans for transactions such as Elon Musk's $44 billion buy of the former Twitter, now X. Only in the past month have the banks, led by Morgan Stanley, been able to sell the loans, originally totaling $13 billion, at face value.

Putting more numbers to the evolution, Fridson said BB credits -- the top tier of speculative-grade bonds -- comprise 52.4% of the high-yield market, compared with 42.5% in 1997-2024. At the low end, CCC and lower-grade credits account for 13.5% of the sector, versus 16.5% in 1997-2024.

As a result, yield spreads -- the extra increment of return to compensate for risk -- should be expected to be lower and less volatile because of the shift upward in quality, Obenshain said.

The shift of dodgier debtors from the public to the private markets may have sharply reduced those spreads, according to Edward Altman, professor emeritus of finance at the NYU Stern School of Business. Since 1986, the average high-yield spread was about 5.2 percentage points over risk-free Treasuries, he said in an interview with Bloomberg last year. Excepting a spike during the Covid crisis in 2020, the ICE BofA High Yield spread has trended under three percentage points. In recent months, the spread has gotten as tight as 2.6 percentage points, coincident with the peak in stock market.

Speculative-grade debt and stocks tend to trade in sync given both reflect investors' assessments of corporate risks and returns, with bond prices falling as yields rise. Since the stock market headed into correction territory, the high-yield spread widened to 3.2 percentage points on March 13, when the S&P 500 closed at its low for 2025 (so far). Coincident with the equity market's slight recovery in the past week, the spread had come in to 3.19 percentage points by Thursday.

That is still a historically narrow yield premium for speculative-grade credit. Part of that reflects the relative scarcity of public high-yield bonds, Fridson wrote in an email, which has made them trade "expensively, " meaning with higher prices and lower yields. That's even taking into consideration the change in the market's makeup toward BB-rated credit. At the opposite end of the credit spectrum, Fridson finds 5.7% of the market trades at "distress" levels, which he defines as a spread of a full 10 percentage points. The 1997-2024 average was 12.6%.

While the siphoning of many weaker borrowers to private credit may have helped narrow spreads in the public high-yield market, that doesn't make spreads a less reliable economic indicator, Obenshain wrote. Investors demand more compensation when they see increased risk. And while absolute spreads are slimmer, they will still move in anticipation of economic weakness, not only among high-yield but also investment-grade credits.

That said, as some of the junkiest borrowers have migrated to private credit, they recently have found their way back into the public market via exchange-traded funds, such as the SPDR SSGA IG Public & Private Credit (ticker: PRIV). For now, the ETF's portfolio consists mainly of public issues, with the biggest positions in agency mortgage-backed and Treasury securities.

Unlike private credit, the risk of what used to be called junk is out in the open. If the public markets start to buckle, the private parts also may be at risk, even if they aren't exposed.

Write to Randall W. Forsyth at randall.forsyth@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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March 21, 2025 14:04 ET (18:04 GMT)

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