Thursday, August 27, 2009
This chart shows the Option Adjusted Spread of the Merrill Lynch Corporate Master Index. That's an index that is currently comprised of some 3800 investment-grade issues with a market value of $2.8 trillion. We've seen a tremendous rally in corporate bonds, as spreads have narrowed from their unprecedented highs of late last year. Those highs occurred last November, when the market feared that the economy was headed for something worse than the Depression of the 1930s. We had never seen such depressed pricing, not by a long shot.
Now, with lots of indicators suggesting that the recession has already ended or is very close to ending, the fears of last November look outrageously wrong viewed from today's perspective. As a result, and not surprisingly, asset markets have repriced. Equities are up over 35% since mid-November, and IG corporate bond prices are up over 20%.
But as this chart shows, credit spreads are still wider today than they were at the peak of the corporate bond debacle in late 2002. That was when financial markets were experiencing unprecedented panic over the prospect of massive corporate defaults (e.g., Enron, WCOM), and accounting and management scandals. We see this same story with the Vix index, which at 25 is still far above levels (10-15) that prevail in "normal" times. Similarly, the implied volatility of bond options is still far above normal or average levels. And of course the spreads on junk bonds are still in the stratosphere.
So we've made a lot of progress to date, with the market's implied economic forecast improving from one of a double-deep depression to one of a nasty recession. Judging from the pricing of corporate bonds today, and judging from the levels of implied volatility, the market is still very fearful of of the future. It may seem difficult to buy stocks and corporate bonds today since they they have rallied so much from their lows, but if you believe the economy is on track for even just a modest recovery, then the market is attractively valued today.
Posted by Scott Grannis at 10:46 AM