Tuesday, October 21, 2008

Swap spreads point to a huge corporate bond rally

Swap spreads are the most basic and the most liquid of credit spreads. They tend to lead other spreads, with the best example being the 2001-2002 period, when swap spreads fell way in advance of other spreads. Swap spreads measure generic or systemic risk in the economy, while BAA spreads, for example, measure the risk of certain types of companies. So it's not unusual that swap spreads should move first. For example, the underlying economic conditions seem to be improving right now, but it may take us awhile to know whether ABC company is going to benefit.

There is a fairly dramatic healing process taking place right now, as evidenced by a plunge in the TED spread (now 263 bps, down from a high of 481), a plunge in 10-year swap spreads (now 40 bps, down from a high of 80), and a plunge in 2-year swap spreads (now 103 bps, down from 167). The implied volatility of options has also declined: the Merrill MOVE index is down to 192 from a recent high of 265, and the VIX index is down to 56 from a high of 81. All of these are measures of fear and systemic risk, and they show significant improvement which probably reflects a) the concerted efforts of the world's central banks to alleviate financial market stress, and b) the free market's own efforts to sort out its difficulties by writing down and absorbing losses.

With the financial markets breathing a major sigh of relief, the next shoe to drop should be a rise in the price of corporate bonds and equities. It's hard to know when that will take place, but corporate bond and equity prices still reflect an inordinate amount of fear and uncertainty. As the chart above shows, spreads on corporate bonds have skyrocketed to levels once thought to be impossible, and equity prices also reflect extremely pessimistic assumptions. But if swap spreads are reflecting some palpable improvement in the fundamentals, it only stands to reason that the outlook for individual companies will start to improve as well.

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