Tuesday, October 14, 2008

Another measure of fear (3)

This crisis wins the modern-day prize for fear, eclipsing by a large margin any of the crises we have lived through in recent decades.. The blue line in this chart is the option-adjusted spread on investment grade corporate bonds. It has reached a level never before thought possible. The average high-quality corporation must now pay 5 percentage points more than the U.S. government in order to borrow money. This means that the market is assigning a high probability to a scenario in which unprecedented numbers of corporate borrowers default on their obligations. Such a scenario would be terrifying if it were to occur, with the only historical precedent of that magnitude being the Great Depression.

In contrast, the red line measures the 10-year swap spread, which is a measure of how much a generic AA-rated bank has to pay above Treasury yields in order to sell its bonds. The red line has typically been a good indication of generic or systemic risk. The huge gap between the two lines is truly unprecedented. We can only draw comfort from the fact that swap spreads tend to move in advance of other spreads, as they did in the early 2000s. If that pattern holds again, then corporate bonds could be the buy of a lifetime at these spread levels, since defaults would likely end up being much lower than the market fears, and declining spreads would result in significant price appreciation for corporate bonds, all the while they pay a much higher rate of interest than Treasuries.

Bottom line: this is one more very graphic illustration of just how much fear and bad news is priced into this market. If you think we are likely to see an economy that is not quite as bad as the Great Depression, then you are, relative to the market, extremely bullish.


Gene Prescott said...

Does the chart say anything beyond depicting level of "fear?" That is, the high price corporations have to pay to issue bonds seems to run counter to the notion that their is plenty of funds available for businesses.

Scott Grannis said...

see my posts from today, I think they answer your question