The high yield bond spread is sending a message

Are we at the peak of the business cycle, or are we still in growth mode? Estimating our current position in the cycle has important implications for portfolio allocation, as asset classes can perform differently in each stage. One way to do that is via the high yield bond spread—here’s what it has to say for allocators. 

The business cycle has four main stages: 

• Recovery: The economic boom begins with positive growth, falling inflation, increased consumer spending, and (usually) lower rates.
• Growth: The economy reaches a sustainable rate of growth.
• Peak: The economy starts to overheat and supply lags behind demand, triggering slower growth, increasing inflation, and rising rates.
• Recession: Growth is negative, along with inflation, as consumer spending and corporate profits fall. 

There are many ways to determine where we are in the business cycle, but one of the most interesting ones uses high yield bond spreads. The paper says that, as well as a macroeconomic indicator, the direction of high yield bond spreads can also function as an investment indicator since it incorporates both the pricing of risky and risk-free assets. The first step is to map the level and direction of the high yield bond spread to the four different stages of the business cycle, using the 10yr median spread and the 3mth change in spread. 

• Above median + falling: Recovery
• Below median + falling: Growth
• Below median + rising: Peak
• Above median + rising: Recession 

A simple strategy of overweighting equities in the earlier stages of the cycle (recovery and growth) and increasing allocations to fixed income near the end of the cycle (peak and recession) would have historically yielded higher returns and lower drawdowns relative to both an all-equity and a 60/40 portfolio. 

Pulling data on the ICE BofA U.S. High Yield Index’s option-adjusted spread from the Federal Reserve tells us that the current spread is 273 bp, the spread three months ago was 286 bp, and the 10-year median spread is 399 basis points. 

With the spread below median and falling, the model is implying that we are currently in the growth phase—where we have mostly been since December 2023. Coupled with continued robust macro momentum in the US (GDPNow estimate for Q1 2025 is currently 3.9%), it seems to make sense for investors to continue to lean towards an overweight in U.S. equites. 

Maverick Lin contributed to this article.