Thursday, December 8, 2011
This chart compares the spread on 5-yr, A1-rated industrial bonds with 5-yr swap spreads. Swap spreads have risen a bit from their lows earlier this year, but are not particularly high, which suggests that U.S. financial markets are only mildly stressed and that the level of systemic risk in the U.S. economy is fairly low. Industrial spreads, however, have risen by a greater degree, and are now at the same levels that we saw going into the 2008 recession. Are credit spreads thus foreshadowing another, and perhaps imminent, recession? I think the message here is too mixed to be conclusive. At the very least, swap spreads would need to be a lot higher than they are today to worry about an imminent recession. But can we safely ignore the message of credit spreads?
I would argue that this chart says the answer to that question is "yes." The chart compares the yield on 5-yr A1 industrial bonds with the yield on 5-yr Treasuries (the baseline against which A1 and swaps are measured in the top chart). Credit spreads are typically thought of as the extra yield that investors demand to compensate for the perceived risk of default. So spreads are a good proxy for default risk. But sometimes spreads can exaggerate default risk, and I think now is one of those times. As this second chart shows, the main reason that credit spreads have increased this year is that Treasury yields have plunged to exceptionally low levels. Credit yields are at their lowest level ever, which means that A1-rated industrial companies now enjoy the lowest borrowing costs of all time. A1 industrial yields today are fully 300 bps lower than they were at the onset of the 2008 recession. That's not exactly the same as saying the bond market is fearful of lending to these companies. In fact, if all you knew was the level of corporate bond yields, you would conclude that the bond market was highly infatuated with industrial bonds.
What is distorting the message of spreads is the exceptionally low level of Treasury yields. Those yields, in turn, are likely being artificially depressed by the world's intense desire for safe-haven assets in a time of great sovereign debt uncertainty in the Eurozone. The creditworthiness of U.S. firms is not the issue. The financial fundamentals of the U.S. economy are not reflecting any significant deterioration at this point.
Posted by Scott Grannis at 9:42 AM