Thursday, September 24, 2009

Credit default swap spreads are narrowing (5)

Another update on this measure of corporate default risk. This chart shows the spreads on generic, 5-year credit default swaps, a proxy for the level of default risk associated with the 5-year debt of companies rate investment grade and below investment grade (junk). Corporate bonds have enjoyed fabulous performance this year as spreads have plunged. The import of all this is that the market is realizing that the economic outlook is much brighter now than it was at the end of last year, and thus the likelihood of defaults is much lower. Easy money also has played a role here, since easy money greases the cash flow wheels and makes it easier for borrowers to service their debt. Even with the huge decline in spreads, however, they remain at levels that in the past would have been consistent with a recessionary environment. So the message of spreads is this: at the end of last year the market was expecting nothing less than a true economic calamity to occur; now it is merely expecting a nasty recession.

This next chart shows the difference between investment grade and junk spreads. This too has declined hugely, but remains at levels that in the past would have signaled considerable economic distress. If you think that the prospects for an economic recovery are at least decent, then corporate bonds still offer attractive valuations

It is very important for equity-oriented investors to pay attention to corporate credit spreads. Analyzing default risk is different from stock-picking, to be sure, but in the end corporate bonds and stocks are part of the same capital market. You can't have one priced to a fabulous outlook for the economy without the other largely in agreement. In this case, while the pricing of corporate bonds has improved dramatically, they still reflect an unusually high degree of risk and uncertainty. I think this gives us a strong clue that equity market pricing is definitely not overly optimistic and most likely very cautious if not cheap. There's still a lot of bad news priced into stocks and corporate bonds. 


Barry said...

Can't you make the opposite conclusion that stocks are indeed overpriced do to the uncertainty and risk premium in the bond market?

Scott Grannis said...

My point here was that it makes no sense to say that (for example) the bond market is priced to a lot of uncertainty but the stock market is priced to a lot of optimism (i.e., bonds are cheap and stocks are expensive, or overpriced). Both these markets are part of the same capital market. Both markets see all the same information. Therefore whatever message you take away from the pricing of these markets, it ought to be a consistent message.

I see lots consistent signs in both markets of lingering and considerable fear and uncertainty. Credit spreads are still historically wide, and implied volatillity in both markets is still well above average. T-bond yields are extremely low, suggesting economic growth expectations are still dismal. Cash yields are essentially zero, suggesting widespread fear of risk. My reading of investor sentiment is that the majority of participants have deep-seated worries about the ability of the economy to avoid another recession.

To me all of these indicators are like snapshots of the same subject, but taken from different viewpoints. They all tell the same story. Both the stock and bond markets are priced to very little optimism and still a lot of pessimism. So valuations are still very attractive, provided you have a constructive view, as I do, of the economy's prospects going forward.

Bill said...


How do current stock prices compare to overall corporate profits?

Scott Grannis said...

It depends on how you measure profits. I've had several posts on equity valuation that discuss and illustrate my variation on Art Laffer's model, which is itself a variation of the Fed Model. Art and I use NIPA profits, since they appear to be the most consistent measure of profits, and also because they are based strictly on reported info to the IRS, and are not subject to distorting factors such as writedowns for goodwill.

Based on that measure of profits, equities are EXTREMELY cheap, priced at less than 50% of fair value.

Many prefer to use GAAP profits. Depending on how you measure GAAP profits for the market as a whole is another issue. If you use a cap-weighted method, you find that P/E ratios are not too far from average. If you use un-weighted profits, then P/E ratios are extremely high.

randy rice said...

I don't know enough about CDS to know the answer, but I wonder if there could be a "new normal" with CDS premiums (and spreads). Are there fewer issuers now, and maybe those issuers are pricing the risk with a little more premium than in the wild west days of AIG?

As an aside, I've tried and failed to find historical yield spreads for municipals and high yield muni's (as compared to treasuries and/or investment grade corporates.) I guess you need a bloomberg terminal for that?


Scott Grannis said...

Randy: I don't think there is any reason to expect a "new normal" when it comes to spreads of any kind. CDS contracts, by the way, are not really "issued" by anyone. They are kind of like futures contracts: for every buyer there must be a seller. They represent the market's best guess as to what a 5-yr spread would be on a large basket of individual corporate bonds.

For good muni and high yield spreads you have to have access to Lehman's, Barclay's, or Merrill Lynch data, all of which I believe is available on Bloomberg.

goldtoes said...

Hey Scott, David here in the UK. Great blog by the way. I have been following for a short time but it's very insightful and compelling. Recently, there has been a blip of issuance on in the Synthetic CDO space, referencing CDS and TRS - issuance source I am trying to determine what are the driving factors for this pick up in issuance. Could it be related to the movement of spreads in the CDS market ? What are the economic fundamentals necessary to make this type of transaction work ? I would love to know your input as I am interested in what will arise from the ashes of the CDO market in general. Best wishes, David.

Scott Grannis said...

It's still a pretty small blip, but at least the market is not completely dead. My only thought here is that since spreads have come in dramatically for all sorts of spread product, that means that a) demand for risky assets has picked up and b) the outlook for the economy has improved. On the latter point, the outlook had been so dismal that "improvement" could mean anything short of a depression. Another think improving the outlook for debt securities is easy money, since that reflates asset prices and improves cash flow, thus reducing default risk.