Thursday, December 17, 2009

Credit default swap spreads are narrowing (6)

Yet another update on this important measure of the likelihood of corporate defaults. Credit spreads have fallen dramatically over the past year, resulting in spectacular performance for corporate bonds of all stripes. When spreads were soaring at the end of last year, it was because the market was bracing for an extended depression and an accompanying deflation. Things didn't turn out quite so bad, so now the market is braced for a run-of-the mill recession. There's still lots of room for improvement, especially now that the Fed once again has assurred us that they are not going to upset the economic applecart by raising rates anytime soon.

When cash yields zero, while other things, like investment grade bonds, junk bonds and emerging market debt carry yields that are still quite high relative to Treasury yields, then to hold cash and not more risky bonds only makes sense if you think the economic outlook is going to deteriorate materially. With credit spreads still at levels that in the past have been consistent with the onset of recession, the bond market is priced to a deteriorating economy. To lose money in corporate bonds, therefore, the economy has to really deteriorate. The Fed is doing its best to minimize that risk, and it is also making the odds of winning a corporate bond bet as high as possible, by keeping cash yields at zero. You should never fight the Fed.

On a related issue, I note that the spread between 2-year and 10-year Treasuries today is as high as it has ever been. A very steep yield curve, such as we have today, is the market's way of telling you that the Fed is expected to raise rates by leaps and bounds at some point in the future. (For example, 10-year Treasury yields imply that the Fed funds rate will average 3.5% over the next 10 years.) In other words, today's steep curve tells you that the market is braced for a significant Fed tightening. The only real uncertainty is when the Fed will start to raise rates. For the Fed to upset the market's applecart, they would have to either a) start raising rates very soon and very fast, or b) not raise rates for a very long time, and then by not very much. To the extent you think both of these alternatives are unlikely, then you should avoid holding cash.

Full disclosure: I am long a variety of funds that invest in corporate, high yield and emerging market debt, and I have zero cash holdings at the time of this writing.


Bill said...


Can you comment on the concerns over Greece's debt problem and its impact on the rest of the world economy?

Scott Grannis said...

I'm not a Greece expert by any stretch, but my impression is that Greece's fiscal problems are relatively minor in the great scheme of things.

Skeptics of the euro have always worried about what would happen if a member country ran into fiscal trouble. Would that precipitate an unravelling of the euro? Would it drag down the other member countries?

I think it's possible that the debt of the Greek government could simply trade like the debt of speculative countries. The market is pushing Greek spreads higher, and that will eventually impose a discipline on the government. Markets can sort out this problem.