Credit Spreads Widen / Muni Auction's Failing

A: This is the most direct way to explain to you that credit markets are still under distress. With all the stimulus we have had; 175 bps of rate cuts, $150 Billion of fed term auctions, project hope + lifeline, rate freeze plans, co-ordinated bail out talks for bond insurers, Buffet's security offer for muni market...corporate credit spreads are STILL widening. San Francisco Fed President Janet Yellen acknowledges this reality, and admitted that this problem was one of the targeted solutions hoped for by fed rate cuts. And is anyone else seeing these muni auction's failing? Umm, this is not so good.

Here is a very brief explanation of corporate bonds. Corporate bonds can offer a high yield compared to other investments. Investors of these bonds take on interest rate risk + credit risk, the risk that the issuer will default on its debt obligations (there is also event risk, but for sake of this discussion lets keep it simple and ignore this for now). The payoff to the investor for assuming these risks is a higher yield. The difference between the yield on a corporate bond & government bond, is known as the credit spread!

The credit spread, whether narrow or wide, reflects the premium that the investor gets for assuming higher credit risk! When credit spreads widen, it is a signal of the demanded premium by investors (via a higher yield) to take on an increased credit risk. This is exactly what is going on right now. The chart below will illustrate to you what is going on.

WIDENING CREDIT SPREAD BETWEEN WACHOVIA HIGH YIELD CORPORATE BOND INDEX vs iSHARES LEHMAN 7-10 YR TREASURY BOND FUND

CHART LINK VIA BLOOMBERG: Simply add "IEF:US" symbol to this chart to compare credit spreads.

Ok, so now you have a general idea of what the widening corporate credit spreads means (higher risk) and a visual showing you that this is actually occurring right now. Now, lets see what fed president Janet Yellen said on February 7th. According to Bloomberg:

"The increase in credit spreads has sort of worked against our policy," San Francisco Fed President Janet Yellen told reporters at her bank yesterday. "The fact that the spreads went up so dramatically really resulted in an effective tightening of financial conditions that our cuts were partly meant to address."

Lets take another angle and try to bear with me here. Check out this TheStreet.com article which discusses, "Soaring Default Spreads Sock A Swap Seller"; which goes into derivatives trader Tom Jasper's trades:

Primus Guaranty -- which reported a $404 million loss in the fourth quarter, its largest ever -- remains a relatively unknown company that is nonetheless a major player in the credit default swap market. Primus essentially does only one thing: sell credit default swaps on single-name corporate bonds.

From 2005 to the summer of 2007, the U.S. CDX investment grade index -- a basket of corporate credits -- generally traded at spreads of below 50 basis points...

During this timeframe of relatively low risk, Primus was a big seller of credit default protection. But in the summer of 2007, spreads on the CDX investment grade index widened to 100 basis points, as fears of the brewing credit crunch drove up the cost of protection. Spreads dipped in the fall, but rose to a record 143 basis points on Tuesday, according to Markit.

Below is the MARKIT CDX.NA.IG Series 9 Index which shows the widening of spreads referred to in the above article which is at a record right now:

KEY:
Left Axis = Index Spread
Right Axis = Index Price
Red Line = Index Spread Widening
Black Line = Index Price Falling



WHAT CDX.NA.IG SERIES 9 MEANS (as I understand it from contacts I know in these markets): NA stands for North American. IG stands for Investment Grade. Every 6 months dealers are polled. They vote names into the new index. We're now up to series 9. To be eligible for a vote you must have contributed end of day marks for X% of days in the last 6 months on the names in the old index; X being a lot. There are a bunch of indices, but the two big ones are HY - high yield, and IG - investment grade. 100 names are in each. You take the 100 names and average the credit spreads to get the CDS spread on the overall index. Bigger spreads = worse credit in the index as a whole. If HY (high yield index) goes from 500bps to 1500bps and IG (investment grade index) goes from 50 to 70bps you know the HY index is getting a lot worse a lot faster than IG in terms of credit quality. Those numbers are just arbitrary to demonstrate a point.

This chart shows us that investment grade credit spreads had risen about 63 basis points in the past 12 days alone! Did I lose anyone? Hopefully not, and maybe it makes a bit more sense now. Here are some quick takes on the failing muni auctions and related articles to these topics. The markets are ignoring these events or consider it priced in already:

Auction-Bond Failures Roil Munis, Pushing Rates Up (Bloomberg)

Bonds sold by U.S. municipal borrowers with rates set through periodic auctions failed to attract enough buyers as banks including Goldman Sachs Group Inc. and Citigroup Inc. that run the bidding won't commit their own capital to the debt. The auction failures provide new indication of Wall Street's unwillingness to commit capital amid $133 billion in credit losses and asset writedowns.

"It's the beginning of the end for the auction-rate market," said Matt Fabian, a senior analyst with Concord, Massachusetts-based Municipal Market Advisors. "Banks have stopped supporting the market."

Multiple Muni Issuers See Notes Fail At Auction (Forbes)

U.S. municipal bond issuers were hit with "multiple" failures of auctions of their paper on Tuesday, industry sources said, as investors fretted about the safety of the bond insurers backing the debt.

As a result, states, counties, cities and towns around the nation now are being forced to pay sharply higher short-term interest rates, in some cases as much as 15 percent.

Corporate Credit Dislocation Persists, May Worsen (Guardian.uk)

Dislocation reigns supreme in the European corporate credit market, with conventional thinking turned on its head over and over again, threatening to delay the return of confidence. High-yield bond investors are worried about what is happening to triple-A borrowers. Secured debt is trading comparably with unsecured debt. And investment-grade credit indexes have performed worse than their riskier high-yield counterparts. And, despite credit spreads being at their widest level since early 2003, things may get worse before they get better, as sentiment remains extremely fragile.

"There's complete dislocation," said Sean Dawson, executive director for structured finance at Lehman Brothers, at a Fitch Ratings conference on subprime securities late last week.

Commercial Real Estate Follow Up: REIT Indicator (UrbanDigs)

We knew spreads had widened, forcing banks to write down the values of some of these CMBSs, but what really worries me is that the widening has continued even as the fed has slashed rates. Fed cuts rates and borrowing cost goes up, not the math we want to see.