Credit spreads still flashing green

Corporate credit spreads are reliable and often leading indicators of the health of the economy. Currently they are trading at post-recession lows, which suggests that the fundamentals of the U.S. economy continue to improve, even though economic growth rates remain disappointingly slow.

The chart above shows 5-yr Credit Default Swap Spreads, which are very liquid proxies for corporate credit spreads and default risk in general. Currently these are trading at post-recession lows, though they are still meaningfully higher than they were in early 2007. I take this to mean that the market is still somewhat concerned about the possibility of future economic setbacks, but for the time being the economic fundamentals look pretty good and are definitely not deteriorating.

The above chart shows the average option-adjusted spread (arguably the best measure of default risk) on investment grade and high-yield corporate bonds. This too shows that spreads are at post-recession lows, but that they remain meaningfully higher than previous lows registered during times of relative economic tranquility. This confirms the message of CDS spreads: the market is still concerned about the future and somewhat risk-averse, but at the same time the market detects no deterioration in the economic fundamentals.

From an investor's perspective, credit spreads are generally attractive, especially when compared to the almost zero yield on cash. From a timing perspective, credit spreads give no indication of any impending deterioration in the outlook. From a contrarian perspective, credit spreads suggest that valuations are reasonably, but not highly, attractive. In other words, the market realizes that economic fundamentals are reasonably solid, but nevertheless the market is not willing to pay relatively high prices for the right to earn extra yield. Purchasers of corporate bonds thus have a modest cushion against things going wrong, but this cushion is an order of magnitude less than it was in late 2008, when markets were priced to something like the end of the world as we know it.

So: a word of caution to corporate bond investors, since risk premiums are still moderately attractive but on the margin much less so; and a word of encouragement to those who believe that the economic fundamentals support further gains in equity prices.