Tuesday, January 17, 2012

Credit spread update

Credit spreads are still elevated, as the top chart of 5-yr generic credit default swaps shows. In fact, today they are higher than they were at the beginning of the last recession. At the very least this reflects a market that is very concerned about the possibility of another recession, and any student of early warning indicators knows that spreads at this level are a classic sign of a recession that is either underway or just about to start. Normally I pay a lot of attention to the level of credit spreads, but now—and I hate to say "this time is different"—is one of those rare times when the signal deserves to be ignored.

The next two charts help explain why things are very different today. The first chart above shows spreads on 5-yr A1-rate industrial company bonds and 5-yr swap spreads (equivalent to AA bank credit risk). Swap spreads aren't particularly high, and aren't signaling any grave concerns, but industrial spreads are at or near levels that have preceded recessions in the past. The second chart above shows the components of industrial spreads: industrial yields and Treasury yields. What should be immediately obvious is that spreads have widened over the past year even as industrial yields have collapsed. It was very different in 2008, when spreads and yields soared at the same time. The key difference today is that Treasury yields are at all-time lows, driven by the world's desperate attempt to find a safe asset. Industrial companies have never had it so good—they've never been able to sell debt at yields below 2%. Firms are not being starved of credit, as usually happens when spreads widen; investors are eager to buy corporate paper because it yields almost twice as much as Treasury debt, which pays almost nothing.

In short, spreads are elevated not because corporate default risk is rising, but because Treasury yields have collapsed.

But couldn't the collapse in Treasury yields be the market's way of saying the end of the world is just around the corner, and that default risk is indeed therefore quite high? If you think that Eurozone defaults are imminent, that they will bring down the Eurozone financial system, and that in turn will precipitate a major global economic collapse and depression, then yes, you will interpret the current elevated level of credit spreads as a bad sign. But if you think a catastrophe can be averted, then spreads today are not a warning, they are an opportunity.

There's not much value in high-quality corporate bond yields, however, as the chart above shows. Earning a coupon of less than 2% on a high quality industrial bond is not going to make you rich, and the bond itself is subject to some price risk if Treasury yields ever move up from today's rock-bottom levels. High-yield (junk) debt is much more attractive, however, since yields are averaging a little over 8%. This gives you some decent protection against defaults and rising Treasury yields.


Benjamin Cole said...

Excellent insights, another solid post.

I have to add the trend on corporate and Treasury yields suggests the market sees nothing but mild deflation or price stagnation in years ahead.

Why are yields so low? It could be the market is saying we are already in deflation. The CPI overstates inflation, and the market senses that. Goods are getting cheaper, commodities are high but probably not at long-term sustainable levels--historically, commodities become cheaper not more expensive. Unit labor costs are falling, and real estate is selling for half-off. The DJIA is where it was in 1999.

It looks like Japan, it walks like Japan, and our central bank quacks like Japan.


McKibbinUSA said...

ECB Pres Mario Draghi stated yesterday that the economic situation in Europe is "very grave" -- taking a chance on averting catastrophe is unnecessary -- better to embrace economic catastrophe as imminent and to configure one's investment portfolio accordingly -- the collapse of sovereign debt is good news for private enterprise -- once sovereign debt is "killed off" as a viable investment, the only investment vehicles left will be corporate stocks, commercial paper, and real estate -- I can imagine a world where private investments become the "safe" investment of choice for financial institutions -- trillions would flow instantly out of sovereign debt into private equities -- imagine if China "sold off" its treasury holdings and instead, invested those holdings into stocks, commercial paper, and real estate globally (!) -- the sooner that sovereign debt is "dead and buried," the better off private enterprise will be -- my advice is to embrace the collapse of sovereign debt while moving agressively into dividend and rent-earning equities -- by the way, I cite Scott's charts as persuasive evidence that economc catastrophe is coming to sovereign debt holders -- everyone should "take cover" in private equities that earn dividends and rent before it's too late...

Squire said...

short.com has a FRED chart showing the massive increase in base money. It is a rocket shot not from NASA but from the Federal Reserve Bank. M1, M2, MZM are skyrocketing.

Squire said...

That is Doug Short - dshort.com, not short.com

Public Library said...

It does look lik emoney stock is starting to go hyperbolic. Especially relative to the past.


Benjamin Cole said...

I advise everyone to check out this website, by a crew of serious guys who are trying to measure the real money supply. It turns out this is not a simple topic.

According to Divisia, the money supply is contracting.

Who knows? But I note that asset values in the USA are falling to flat, and unit labor costs are falling.

I contend the Fed is passively contracting the money supply by not more aggressively pursuing QE.

We know from Japan that merely low interest rates are not enough, and do not indicate an aggressive or pro-growth money supply. Deflation has been the rule in Japan for 20 years, and the yen has soared and interest rates have been at zero to 1 percent.

Really this is obvious--The Fed, like Japan's central bank, is suffocating the economy.

Benjamin Cole said...

BTW, the website I encourage all to visit is:


This might explain why the economy moves like it is on Sominex.

Public Library said...


That is because shadow banking and consumer balance sheets are contracting. However, printing tons of money either way never ends in prosperity.

The Fed is basically commanding where the market allocates resources. This too will not end in prosperity for the real economy.

William said...

Scott -

Thank you for the very informative analysis.