372. Are credit spreads really expensive?

23 October 2025 (pre-recorded 8 October 2025)

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[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. We’re taking a closer look at the world of corporate bonds today, exploring how spreads, duration and credit risk influence bond valuations.

Darius McDermott (DM): Hello, I’m Darius McDermott from FundCalibre. Today I’m delighted to be joined by one of my favourite fixed income fund managers – that’s bonds to the rest of you – somebody I’ve known through multiple phases of his career, and we have long standing been investors and supporters of his franchise. Thank you for joining us, Stephen Snowden.

Stephen Snowden (SS): Thank you for having me.

[INTERVIEW]

DM: Steve is the lead manager on the Artemis Corporate Bond fund amongst co-managing on a number of the other Artemis bond strategies. So, look, you and I, Steve, we can talk about bonds all day long because we sort of, at least I speak most of your language fluently, but it does appear given, we’re gonna talk a little bit technical today that an introduction to what some of this terminology is. And I think the one I’d like to start with is the word ‘spread’. So you and I would talk about spreads over this or over that. What does the spread mean as basically as you can manage it to explain to retail public please.

SS: Sure. I’ll try my best. So theoretically at least, and this is how the market operates, and we could go into a conversation later as things have changed a little bit, but theoretically a credit spread spreads or credit spreads is the additional yield that you get for lending to a person or to a company over and above what you would get for lending to a government or a country.

So, for example you should expect a Tesco bond to give you a higher yield than a UK government gilt. And the difference between those two yields is the spread. So if that Tesco bond had a five year maturity, and we will come to maturity next, you would want a spread over the five year gilt to be correct. To be worthwhile.

DM: So it’s that sort of risk, not risk free, but it’s the risk premium that you should expect over the government bond of a similar length of time. So then let’s talk about spreads. That amount of money that you get paid for lending to that individual or company known as the credit spread is a part of the corporate bond overall pricing. Tell us what’s happened with spreads and what a tight spread means to a general valuation of a bond or indeed a bond market.

SS: Sure. The corporate bond market, you could argue, has existed as far back as railway the ventures in the mid-1800s, but it really only got going in the UK like for a proper diversified market in the 1990s, and very much so only fully really developed over the last 25 years.

Now, credit spreads go up and down. So when they’re large or high that means the market is very nervous usually during a period of economic stress. And whenever the spread is a small number or low or tight as we call it then that means people think, you know, the economy is strong and there’s nothing to worry about. Right now, credit spreads are what we call tight towards the expensive end of the valuation range. So roughly speaking you’re getting about 1% more in a corporate bond than you will do on an equivalent maturity gilt, the records sort of high has been close to over 500 based on your 5% additional yield.

The normal range is probably 1%-1.5% more than the equivalent gilt credit spreads have been tighter in the past, but that has been a pre-financial crisis and credit spreads reset wider thereafter. Now we can go on to what I think about the valuation, but as things stand just optically, if you were to look at a chart of credit spreads, you would say they’re on at the expense of end of the trading range today.

DM: So like other assets, I suppose when there is that uncertainty and unease, either because of financial crisis or COVID or any other macro shock for buying, or for you in your case, lending to a bond issuer, you get paid more. And in times where market seems sanguine and the company, the chance of that company going bust and not paying you back or lower then that spread is less. And the value opportunity is there so less as well. So how do you then, in this expensive spread market, if you like, or where do you go to get your opportunities within credit today because this is a credit fund.

SS: Yeah, so just I think it’s important just to point out that be you a corporate bond fund manager like myself or an equity fund manager, we’re kind of both in the same camp at the moment. You know, when credit spreads are tight as they are today, the equity market is usually pretty well valued. And when credit spreads are wide, then you know, the equity markets have usually fallen quite dramatically. There’s a very, very strong correlation between credit spreads and the how strong or weak the equity market is.

So I would say valuation opportunities, whether you look at corporate bonds, are equities are hard to find at the moment. So I don’t think that is uniquely a corporate bond challenge. We have had at Artemis, you know, probably a contrarian view on the market this year. We have been arguing despite credit spreads being at the tight end of the trading ranges that they will continue to improve or tighten and therefore make capital gain.

That is exactly what we have seen this year. Why have we had that view is because the the risk to lending to companies and to individuals has continued to reduce. There’s two broad aspects to that. First of all, the corporate bond market is becoming having shorter duration. Now to put that into plain English, that means the average maturity of a corporate bond has reduced quite dramatically over the last few years. Companies when they’re issuing new bonds today are typically issuing in shorter maturity bonds, so maybe five years or 10 year maturity bonds.

If you go back 10, 20 years ago, it was quite common for companies to borrow for 20 or 30 years. So there’s less long dated bonds around today than there used to be. So the market is shorter or has less average maturity and it stands to common sense, the longer time period you lend money for the greater the compensation you require because there’s more things that can go wrong over an extended period of time.

So that’s why, you can get payday loans. Okay, the yield is very high, but you know, it’s a very short time period. And then you get the very long tiered loans. Anyway, cut a long story short, because the market is a lot shorter today, you should expect less compensation. So many market observers and commentators look at credit spreads today and say, they’re very tight compared to history, which is true, but we have never had the market with such a short average maturity as we’ve had today. So all things being equal credit spread should be the tightest they’ve ever been in history and they’re not. And I think a number of people have not fully appreciated that that point.

The other thing that’s important to bear in mind is the credit risk that we are taking lending to companies and to people has continued to improve or reduce over time. Company balance sheets are much less levered than they were 10, 15 years ago. The same is true for personal indebtedness. Personal indebtedness in the UK for example grew rapidly. People took on more and more credit card debt and mortgages, et cetera, personal loans up until the financial crisis. Ever since then, there’s been a big reduction in personal in debt in the UK over the last 15 to 18 years.

So we’ve got two important factors here. The credit risk is less. All things being equal credit spread should be the tightest they’ve ever been in history layer on the fact that we’re lending for a shorter period of time, all things being equal credit spread should be the tightest they’ve ever been in history. Put the two of those together and I would argue credit spreads are still cheap or still have room to improve. And I think the optical observation that people make is wrong and will continue to be wrong.

DM: So just another piece of jargon there, a terminology which we talked about balance sheet and leverage. So let’s just as we’re trying to do a bit of education as well as an update, an individual or a company’s ability to pay your interest for lending to them, if they have more debt, they may come under calls to pay that debt elsewhere rather than paying you. So if they’ve got a stronger balance sheet or less debt as a bond manager, you are more likely to get your coupon paid. Is that how you would describe it?

SS: Absolutely correct. So the financial risk is much, just think of your own personal situation. So whenever my first mortgage when I was, you know, this will quite unusual to the modern generation, but I had my first mortgage at the age of 24. I think the average today is more like 35, but I got my first mortgage at the age of 24, a 95% loan to value mortgage. Now a 24-year-old on a 95% loan to value mortgage is much riskier than a 40-year-old or on a 50% loan to value mortgage. So, you know, we could think of, I was a startup company with very high leverage. So I was a high risk when I was 24. But if you’ve been in your career 10, 15, 20 years, and you’re only borrowing half the value of the house from the bank’s perspective, house prices can fall dramatically and they still won’t take a loss on the loan or on the mortgage. Whereas if you’ve only got a 5% deposit, if housing market falls 10%, the loan’s worth more than the house and the bank is in a pure credit recovery situation. So that’s the way to think of companies. Just the way you think of a mortgage, basically the loan to value on your house has fallen from probably 75% to 50%. That’s the way to think of corporate balance sheets much, much more robust today than they have been.

DM: So look, when I think about bonds, and I believe, again, I’m trying to keep this fairly simple, there are two risks that we have. We have discussed the credit risk, which is the amount of compensation that you might expect for lending to a company or an individual. The other risk then is the duration or the length of that loan, which is called the duration. If I loan to you for five years, the duration is five. Maybe explain how that works in the context of a fund and what an average duration means. And then maybe just a little bit about the risk that comes with that duration and why one does increase or decrease it. And then we’ll come talk about what you’ve done in the fund.

SS: Yeah, sure. So we use the phrase duration as a it’s basically a mathematical average of the sort of like what is the average maturity of the bond in your portfolio. So the bigger the number the longer time period you’ve lent money for just like credit risk, the longer you lend money for, the more things that can go wrong, you know, from a duration point of view are an interest rate, risk point of view.

As we should probably say, there’s more chances of an adverse change in the interest rate environment the longer that you lend money for. So you should, theoretically, all we see is upward what we call an upward sloping yield curve. That means theoretically you should be paid more for lending for 30 years to the government than you should over five or 10 years.

So the longer the maturity or the higher your duration, the more risk that you’re taking. So you, you are taking the risk that inflation might increase unexpectedly over time that pushes up interest rates or the Bank of England base rate. When that happens, that is typically bad for the bond market that forces prices to fall to generate, to compensate you for a higher yield to compensate for a higher inflation and a higher bank of England base rate. So the bigger your duration number, the bigger your risk.

If you look at the corporate bond market, if you go back five years ago, the duration, our average maturity was eight and a half years. Today it’s about five and a half years. So you can see there’s been a dramatic reduction in duration, which means a dramatic reduction in risk. And that dramatic reduction in risk is twofold, is both interest rate risk today is a lot less than it used to be. And also because you’re lending the companies the credit risk is a lot less than it used to be.

DM: And that’s at the index level, I guess, and touches on what you’ve said is that the overall markets duration has shortened and hence that duration risk by definition has shortened, which leads into your observation about the credit part of the bond not being as maybe as expensive as others might comment on.

SS: Correct.

DM: So without, again, getting too technical, there’s two ways you can change the duration of your fund. If you have a view on interest rates going up or down, or inflation, whether that’s in line with market or against, you can, if you want to lower duration, you can sell some 10 year bonds and buy some three years. And if you want to do the opposite, you can sell some three year bonds and buy some 20 year bonds based on your views.

Then you can also use derivatives occasionally to alter that because you still like the bonds. So you can change that profile of the overall maturity. What have you done in the last, say, six to 12 months? And why? And maybe this leads into a little bit of outlook as to how you see maybe the six months ahead. I won’t hold you to any longer than six months.

SS: This part of the conversation always comes a bit more complicated because we have to discuss the political backdrop. And everybody will have their own views on whether the current government is doing a good or bad job, and everybody has their own view on economics. But what we have to reflect on is the market is the market, and the market is deciding in our good what all investors are thinking.

So what we have seen over the last year is, despite the Bank of England cutting interest rates, as inflation has continued to fall, as it was forecast to do gilt yields have increased particularly 10, 20 and 30 year gilts. Now that is a little bit complicated for somebody who doesn’t spend their day looking at bonds theoretically as base rates it’s come down, the gilt yield should also come down, but the reverse has happened.

It’s more complicated than that. So the curve is what you called <inaudible>. So we’ve had the yields on 1, 2, 3, and four year bonds fall, and that’s very much governed or driven by the fallen base rates at the Bank of England. But because people are the market or investors in aggregate have decided the UK is less credit worthy than it has been, people are nervous about lending to the UK government for 10, 20 and particularly 30 years. So you may have seen in the press over the last month or two 30 year gilt have reached levels that were last seen back in 1998. So the government the government bond market has decided, you know, irrespective of your politics, the market has decided that the risk to lending to the UK government has increased. And that that certainly was not helped by the government’s inability to pass welfare reform a couple of months ago.

DM: And I think you’re right, Steven, irrespective of your politics, we know what happened when Liz Truss was prime minister. She brought a budget and the gilt yield rose dramatically, and that ultimately cost her job. But in the last certainly three months, certainly throughout the summer, the gilt yield was at the 30 year gilt was at an even higher rate showing. I think to your point, that people are wanting higher compensation for loading to the UK government for a long time, or the flip side is worried about the ability of governments to balance their budgets.

SS: Correct. But I think we also need to put some balance into the conversation. What we have seen in the UK were particularly long dated bonds have risen considerably in yields. That’s not simply a UK phenomenon. We have seen exactly the same thing in Japan in the US and in Germany, all for slightly different reasons. But what is a global problem is that the developed world is struggling to live within.

This means we are borrowing more money to pay for more government spending than we’re raising in tax revenues. And ultimately that that can’t go on forever. The bond markets globally, including the UK are signalling that we should also just for some balance as well to say part of the reason for the sell off or, you know, the yield being so attractive on long dated bonds is that inflation has picked up a little bit.

Inflation continues to be stronger than many would’ve forecast. That means inflation while coming down over the longer term is still being sticky on the way down. And that’s what we’ve seen with the last Bank of England base rate cut when they cut to 4%, although they cut base rates from 4.25% to 4%. You know, it was the messaging that went around that cuts was hinting towards the stickiness of inflation. So the Bank of England has been, you know, probably signalling to the market that it’s gonna be less aggressive in cutting interest rates, which has fed through to a, what we call a steep yield curve or higher dated higher yields on, on long dated bonds.

So look, it’s not, it’s not all down to a unpopular UK government. This is a global phenomenon that we have seen. That all said, I mean, in terms of what we are doing or how we are positioned or what we have done we, over the last 12 months or so, we have been running a curve steepening position, which basically means we’re very underweight these long dated bonds. And that’s been to a great benefit to the fund.

We have, however, more recently moderated the that position because we are now at yield levels that we haven’t seen since 1998. We have very attractive, real, real yields at the long end. So what that means is you can buy a 30 year gilt, let’s call it 5.6% at today’s money, roughly that inflation is currently 3.8%. It will come down aggressively early next year. So right now you’re looking at a real yield. That’s the difference between the yield that you’re earning and inflation of close to 2%, and that could easily be 3% this time next year. That’s a very attractive way to protect your money against the ravages of inflation over a long period of time. So inflation, so the inflation adjusted potential returns here at the minute are very attractive and that’s why we are certainly much less negative on the gilt market than we have been.

DM: Okay. So look, I think we’ve done a reasonable job of trying to demystify some of the terminology that you and I speak about on maybe a day-to-day basis. And you, with your colleagues. For our listeners, you are sitting at the nerve centre of the Artemis Fixed Income Department. I think you’ve said, and you correct me, I know if I’m wrong, but you’ve said that you don’t think spreads are super expensive. Given the other factors we’ve already touched on at inflation, you expect, I think, to come down what then, and we are approaching well, but still in early October, but we’re approaching the end of 2025.

What sort of return might we expect from a sterling corporate bond? And let’s just remind our listeners that means it’s gotta be 80% in investment grade bonds, even if they’re borrowed in other denominations, hedged back into sterling. What sort of return might we look for the 12 months ahead as we sit here in October?

SS: This is my least favourite question.

DM: That’s why I like to finish with it.

SS: So, because something always comes along that you can’t expect, you know as a fund manager you know, it’s great if you can predict the future and very few of us do that successfully. I think your scale has to be how you react as the information set on those rapidly. But as things stand, as we look today, the yield on the corporate bonds market is about 5.5%. And so assuming nothing goes wrong, we should at least get that return.

I would argue over the next 12 months, I do believe that the concerns that the market has about the state of the UK public finances are, you know, that’s not new news. Everybody is aware of that. I think we could be towards peak concern there is room for the gilt market to improve next year, particularly as inflation starts to come down. I do believe credit spreads, unless the unexpected happens, have room to improve. Again, both those things should lead to some degree of capital return as well.

So I’m not allowed to make a forecast that’s a regulatory requirement. But you know, there is certainly the, the, the starting yield of 5.5% today, plus the potential for some capital gains, I think makes corporate bonds a interesting alternative to sitting on cash, particularly as base rates will continue to fall and we’ll get a lower and lower yield on cash as time go on.

Look, we’re never gonna be able to compete against Apple shares or Tesla shares or Nvidia shares or whatever ever, you know, equity that’s or gold, which is obviously been very strong of late. But I do think, you know, for the risk that you’re taking you are looking at a very attractive return relative to cash and to inflation over the foreseeable future.

DM: Stephen, Thank you very much indeed. I thought that was a really interesting chat.

SS: Thank you.

SW: Stephen brings his considerable experience in investment grade fixed interest to this fund. He combines his knowledge and understanding of the macroeconomic backdrop with his credit analysis and technical understanding of the bond market. He and his team have a strong process and good track record investing in corporate bonds. To learn more about the Artemis Corporate Bond fund please visit fundcalibre.com