Higher credit yields increase corporate capital costs.
And higher cost of capital puts pressure on coverage ratios and corporate profitability.
With lower coverage ratios and lower profitability, credit risks increase, and the result is that credit spreads should go wider.
That is, however, not what is happening at the moment. The current disconnect between credit yield levels and credit spreads is significant, see chart below.
Maybe what is happening today is similar to what happened from 2003 to 2007, when yield levels kept increasing and spreads stayed very tight, see again chart below. Only when the economic data started weakening did credit spreads begin to widen.
With the Fed trying to cool down the economy to fight inflation, the risks are that credit spreads will widen once the Fed succeeds with pushing the unemployment rate higher.
Source: Bloomberg, Apollo Chief Economist. Note: Index used is LUACTRUU Index.
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