Catalysts for a risk reset

Little room for the market to absorb unexpected negative events

In 2025, high-yield spreads began a year with the market spread below 300 basis points (bp) for the first time since 2007. While spreads hit multi-cycle lows in 2024, the low volatility grinding market environment was similar to 2017 and 2021, when in both cases volatility picked up the following year. The same was also true for 2007: The market started the year with spread levels in the high 200s and finished at almost 600bp following a very bumpy second half of the year.

There is no certainty that volatility will return in a meaningful way in 2025, but history has shown that periods of low volatility and compressed risk premiums tend to get upended by something that the market didn’t see coming. At current spread levels, there is little room for the market to absorb unexpected negative events.

We can point to many examples of excessive liquidity in markets today. Retail favorite stocks like Tesla are experiencing massive gains that are detached from fundamentals. Over the past year analyst expectations for Tesla’s 2025 EBITDA have declined by about 30%. During this same period the stock returned over 60%. There are several other examples in markets where individual investor sentiment appears to be driving outsized returns.

While likely not quite as unpegged from fundamental value as some individual equities, there are also examples in credit markets. We participated in a new issue Commercial Mortgage-Backed Securities (CMBS) transaction in early January for the Spiral, a trophy office tower located at Hudson Yards in Manhattan. We bought the F tranche, which priced at a spread of 310bp. In this same transaction, both the D and E tranches were more than 40 times oversubscribed at initial price point. The F tranche priced at a level we thought was fundamentally cheap to the D & E tranches because it had a high yield rating, while all other tranches in the structure were rated investment grade.

Catalysts for a risk reset

There are multiple potential catalysts for a risk reset in 2025. It seems likely that tariffs will be a focus for markets in the coming months, which is unlikely to be a positive development. Another concern could be the unsustainable fiscal position that many developed economies find themselves in, particularly the United States and France. Conditions could be ripe for a return of bond vigilantes to push back on the supply of securities required to fund deficits in excess of 6% of GDP.

With so much optimism priced into markets going into 2025, it will be a high bar to clear for reality to live up to expectations this year.

Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund. Excerpted from Pender Alternative Absolute Return Fund Manager’s Commentary, December 2024. Used with permission.

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