Gauging Market Sentiment on Risk Using the IG/HY Spread

When the spread between High-Yield (HY) debt and Investment Grade (IG) debt contracts or expands, this can be perceived as the market demanding more or less compensation for the risk it perceives to be present in owning the HY debt against the IG corporate debt. (HY-IG) = Risk On/Risk Off market sentiment.

Generally speaking HY debt a.k.a. Junk Debt, is considered more risky than IG debt. Because of this increased risk, the market demands a higher yield for taking on HY debt, also known as a ‘risk premium’ or ‘premium’ over the alternative investment opportunities the market provides.

This yield premium on HY/JunkBonds can be viewed as ‘extra incentive’ for bids to take on the ‘riskier debt’. When this spread (white) contracts, we can see that the market (yellow) has a tendency to go up (risk on) and when the spread (white) expands we can see the market (white) has a tendency to go down (risk off). This is only one of many indicators I use to gauge ‘market risk sentiment’ and I thought I would share it. (Not financial advice.)