Goldman Sachs: US Treasury Yields Rise, Credit Spread Widening Narrows, Recommends Buying Volatility

Overview

This report by Goldman Sachs Global Credit Trading team focuses on the impact of macro forecast changes on credit spreads and trading opportunities in credit volatility. As US activity and labor market data came in stronger than expected, Goldman Sachs economists postponed the final two rate cuts of this Fed easing cycle to June and December 2027 and raised the 10-year US Treasury yield year-end forecast from 4.1% to 4.4%. Against this backdrop, while still expecting credit spreads to widen by year-end, the magnitude of widening is narrower than the March-end forecast. The report analyzes the credit volatility market, noting that current implied volatility is at historically extreme low levels with a steep term structure, and recommends investors buy short-dated volatility to hedge potential tail risks. Additionally, the report updates spread forecasts, total return expectations, and relative value views across major credit sectors.

Core views

Macro and Spread Forecast Adjustments: Given strong US economic data, the unemployment rate is now only expected to rise modestly to 4.4%, reducing the urgency for an emergency Fed rate cut. The higher US Treasury yield path provides technical support for credit bonds based on yield demand, partially offsetting the upward pressure on risk premiums. Consequently, Goldman Sachs lowered its year-end USD IG spread forecast from 92bp to 85bp, and USD HY from 325bp to 305bp; expectations for EUR market spread widening also moderated, but EUR IG is still forecast to widen to 91bp and EUR HY to 320bp by year-end. Credit Volatility Trading Opportunity: Credit implied volatility is currently significantly lower than equity implied volatility. CDX IG 1-month implied volatility is at the 20th percentile post-GFC, while the VIX is at the 79th percentile. This divergence partly reflects the more diversified nature of credit index constituents compared to the tech-heavy equity index. More importantly, the correlation between interest rate volatility and credit spreads has risen significantly since 2022 (from 0.65 to 0.82), as investment-grade bonds now behave more like yield products than spread products. The current 'volatility premium' (the difference between implied and realized volatility) is at an extremely low 10th percentile historically, suggesting options are statistically undervalued. Additionally, the volatility term structure is unusually steep, with short-dated volatility extremely low. Based on this, the report recommends buying 1-month and 3-month credit volatility to bet on a normalization of the volatility surface and to hedge tail risks such as a commodity market disruption. Relative Value and Sector Views: On a regional comparison, the preference for the USD market over the EUR market continues, as the European Central Bank (ECB) is raising rates amid weak growth, leading to a wider peak in EUR spreads and a slower recovery. Within the USD high yield market, CCC-rated bonds have underperformed recently and dragged on the overall index, but BB-rated bonds remain favored due to their lower floating rate debt in capital structures and relatively solid fundamentals. The spread relationship between BB and BBB is expected to remain range-bound. In the EUR high yield market, some modest underperformance of HY relative to IG is expected. Total Return Expectations: Affected by a higher US Treasury yield floor, the full-year 2026 total return forecast for USD IG is 3.3%, and for USD HY is 4.9%; total returns for EUR IG and HY are also in the low-to-mid range of historical distribution. This suggests that despite coupon protection, price depreciation pressure limits total return potential.

Analysis framework

Goldman Sachs' analytical logic follows a path of 'macro-driven -> spread revision -> volatility validation -> relative value selection'. First, by updating macroeconomic forecasts (especially the Fed policy path and Treasury yields), it reassesses the risk premium and technical demand for credit assets. Second, it uses historical correlation analysis (e.g., changes in the correlation between interest rate volatility and spreads) to explain the reasonableness of current spread levels and introduces 'volatility-adjusted spread' metrics to evaluate valuations. Third, it delves into the term structure and skew of the credit volatility market, identifying signals that implied volatility is undervalued, leading to specific derivative trade recommendations. Finally, it combines regional growth divergences and monetary policy differences to derive cross-market and cross-rating relative value conclusions. This methodology emphasizes that in a low volatility environment, one should not only look at direction (spread widening or tightening) but also whether volatility pricing fully reflects tail risks.

Methodology notes

• Valuation Method

  Volatility-Adjusted Spread

  Adjusting valuations by dividing credit spread by implied volatility. In a low volatility environment, even if nominal spreads are narrow, the volatility-adjusted spread may not appear extremely expensive, helping to more accurately assess the relative valuation levels of credit bonds.

• Quantitative/Factor/Portfolio TheoryBeta/alpha analysis

  Correlation between interest rate volatility and credit spreads

  The report notes that as investment-grade bonds increasingly behave more like yield products, the correlation between their spreads and interest rate volatility has risen significantly (from 0.65 to 0.82). This means that when analyzing credit bonds, interest rate volatility must be considered as a key risk factor, not just credit fundamentals.

• Event Game Theory & Behavioral FinanceExpectations gap/expectations management

  Volatility Premium

  Refers to the difference between implied volatility and realized volatility. When this premium is at historically extreme low levels (e.g., the current 10th percentile), it may indicate that the market has underestimated future actual volatility risk. At such times, buying volatility (options) has a statistical advantage because option prices are relatively cheap.

Key data

• 10-Year US Treasury Yield Year-End Forecast4.4%Upward revision from previous forecast of 4.1%, reflecting a higher yield floor
• USD IG Spread Year-End Forecast85 bpDownward revision from previous forecast of 92 bp, currently around 73 bp
• USD HY Spread Year-End Forecast305 bpDownward revision from previous forecast of 325 bp, currently around 271 bp
• EUR IG Spread Year-End Forecast (Bloomberg Index)91 bpCurrently around 78 bp
• EUR HY Spread Year-End Forecast (Bloomberg Index)320 bpCurrently around 281 bp
• 2026 Full-Year USD IG Total Return Forecast3.3%In the low-to-mid range of historical distribution over the past 25 years
• 2026 Full-Year USD HY Total Return Forecast4.9%In the low-to-mid range of historical distribution over the past 25 years
• CDX IG 1-Month Implied Volatility Percentile20th percentileAt extremely low levels post-Global Financial Crisis

Impact & implications

For credit bond investors, higher US Treasury yields mean limited capital gains space, with total returns relying more on coupon income. The narrowing of the spread widening magnitude alleviates some downside pressure, but tail risks (e.g., commodity market disruption) remain. The report recommends buying short-dated credit volatility to hedge potential sharp market moves at a low cost, especially given the current extremely low volatility premium. In terms of allocation, USD credit bonds are more attractive relative to EUR credit bonds, and within the high yield sector, avoid CCC-rated bonds affected by floating rates and geopolitical risks, and pivot toward more fundamentally robust BB-rated bonds.

Risks

• Commodity market disruption lasting longer than expected, leading to downside risk in credit valuations.
• Fed policy path deviates from baseline, such as a scenario with no cuts or even rate hikes (probability already raised to 20%).
• Sustained weakness in European economic growth combined with ECB rate hikes, causing EUR credit spreads to widen significantly.
• Credit volatility fails to normalize as expected, leading to losses on the long volatility strategy.

What to watch

• Subsequent evolution of US inflation and employment data and its impact on the timing of Fed rate cuts.
• Supply-demand conditions and inventory levels in commodity markets (especially energy).
• Changes in the credit implied volatility term structure, particularly the 1-month and 3-month volatility levels.
• Eurozone government bond yield movements and ECB policy direction.