Corporate Bond Spreads Still Show Distress
A: Just a quick checkup into the spreads between High Yield corporate bonds to treasuries shows continued distress on the outlook of riskier companies. Given the actions taken by the Fed/Treasury, it will be interesting to see if there is a lagging improvement in these spreads. Also, we must take into account that the spreads would be tighter if it wasn't for the huge rally in treasuries, sparked by QE talk by Ben & Company that they may purchase longer term treasuries to help drive down rates.
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.
These rising spreads reflect investor sentiment of increasing risk that the borrower will default on its debts. As this spread widens, borrowing costs for riskier corporations rise eating in to potential future profits. Combine this with the economic slowdown, and the process feeds on itself. Rising borrowing costs + deteriorating macro fundamentals = increased pressure on the company to maintain/drive future profits. This is one area of the credit markets that have not come in noticeably. Everything else, LIBOR/OIS/TED has come in noticeably. A good sign.
Let me try to relate to those that come here for Manhattan real estate discussions, and who may not understand these macro discussions. Lets say you are trying to sell a property in today's tough market. Now lets say that Bloomberg raises property taxes on you by 10% to help fill budget gaps. How ill this affect you? Well, for one it will make the costs to carry the property rise and therefore make the property less affordable to a potential buyer. This rise in carrying costs should have a negative effect on the purchase price on the open market because as carrying costs rise, affordability goes down. The discrepancy is made up for in the purchase price. Just a simple little analogy for those that don't quite follow the corporate bond markets as a sign of credit stress. Not quite the same, but it should help explain that when corporate bonds are distressed like they are now, borrowing costs rise making it a bit tougher for the company to maximize profit potential; just like if a seller's property taxes rise 10%, it would make it tougher to maximize the selling price.
With 10YR treasuries yielding 2%, and HY bonds yielding mid 10s%, I wonder if future money will start to go for the risk and bring these spreads back in!
Posted by mh23
Sun Dec 21st, 2008 12:21 PM
Great post. Merrill's Chief Economist, who I find to be very accurate, believes that these spreads will come in as we get into Q1 09. Rosenberg argues that, as the ZIRP policy remains in place, people will want more yield than near zero, and they will first look to AAA and AA muni's, (I own Port Authority NY/NJ yielding around 5.25% tripple tax free) and after that they will look to corporate bonds that are AAA or AA (For me I own MET prefferds yielding 11%) and some will even look to MBS' for higher yields. That is fixed income.
After cash has moved into these arenas, which will overtime narrow the spreads, people will then begin to look into the equities market as a source of growth. I for one have no idea whether or not we have bottomed, I can just as easily see a rally to 11k by Q2 09 as I could see the dow at or below 7k. For me, I have been buying equities over the past 9 weeks, adding to positions on the dips and selling a bit on major rallies (e.g. I traded my FDX, V and AA positions at a 20% plus gain, and the I bought AA again back at around 9. I like FDX and V, but have not bought them again yet).
As always, I appreciate your posts. You have definitely helped to educate me on GOLD as well as certain dynamics in credit markets that I might have otherwise overooked.
Posted by Noah
Sun Dec 21st, 2008 04:06 PM
great to see you like the site mh23...keep up w/ the comments too!!
Im not so sure how strong any rally may be, cause I think the depth of this will be worse than what is priced in now, but you never know. Such unchartered territory here. Im just waiting to wake up to a few down limit days, has to be. They always come later on too, after you think the worst is over, and the fed doesnt have much left, and a big company warns or goes bankrupt, or an accounting scam revealed, or some other surprising event. So, I worry still about this, more delevraging, more forced selling and maybe a few more bank scares. But who knows. We are getting close to past all the volatility and that should be good for longer term institutional investors and when that happens it should be a good move for equities.
I dont take much risk on long side, and if I do, I sell most after 12-15% rally in major indexes. I just started putting minor shorts on past few days. I think the rally here lasts a few more weeks, but to me, I think its a short. Just trading this while the fun lasts!!
:)
Posted by patient09
Sun Dec 21st, 2008 06:22 PM
hyg and lqd if you like this trade idea
Posted by Noah
Mon Dec 22nd, 2008 12:12 PM
thanks patient..Ill check those out..Mainly playing eev, fxp, srs, skf, mzz, sds, dxd
Posted by sfone
Mon Dec 22nd, 2008 05:54 PM
Noah,
As a follow up to the LQD mention by one of your readers, many of these underlying bonds- which are all IG- have moved up well over 20% since the Oct 10 lows alone. The PEP, T, IBM sr unsecured notes have all been on a daily march higher nearly in a straight line. While I've seen reports that current HY spreads imply >70% cumulative 5 year default rates with 30% recovery rates (much higher than depression 1931-1936 levels), I am working under a slightly different assumption as to the triggers of certain HY indices performance. I am FULLY convinced that CDS activity and it's disproportionate impact across all other pieces of the capital structure, in conjunction with a complete breakdown of liquidity in the debt capital markets, is forcing these spreads wider. The WSJ sniffed around this issue a few weeks back but failed to put their finger on exactly how it may play out in the markets. aka- Step 1- short common stock step 2- short the corp debt step 3- buy your CDS on that company and disproportionately impact each of the two jr pieces of the cap structure. I can't prove this but my sense is the manipulation within the CDS market suffers from the same gross misappropriations as what transpired in the oil markets this summer. While MANY (nearly all) academics spent much blog-space and time writing of how passive investment flows did NOT unduly impact oil prices for one reason or another, I believe many of the same forces are at work, just with less visible waves on the surface.
While the substantive repricing and recalibration of risk premia is proving quite painful, I would argue that measuring the degree of "healing" using 2005-2007 levels as "normal" is inappropriate and may lead to the wrong conclusions.
And as a follow up on NYC RE, after visiting multiple open houses this weekend, very few if ANY homeowners understand the severity of this crisis yet and are reluctant to lower their asking prices to anywhere close to levels that will interest me. In fact, I was still offended by certain asking prices and opposite of most, I believe these levels reflect a total LACK of confidence from the seller's perspective on what market value truly is, as if they really did believe that their apt was "special", they would price it lower and let the buyers bid it to that value rather than letting it sit with all the others..That's fine until personal financial conditions change, but until i see real changes, I'm done with open houses
Posted by Noah
Mon Dec 22nd, 2008 06:53 PM
sfone - wow, thanks for your comment. I love the detail. Please keep it up with future discussions as I enjoy learning from readers who comment.
Thanks.
As per NYC re, you are 100% right. That is the case. Mainly its because sellers are in denial, believe their property is worth more than previous sales, and interview 3-4-5 brokers who are trained to mention that they are the best and can get the best price and that their property is 'def' worth a very hig price. That is how they secure the listing agreement, and then the job is to get the price down after. Sellers fall for it, list, waste time, and find themselves behind the curve. Then they call me, well at least 6 did in past month alone.
Sweet, yay, great. Come to me for reality after they signed with another broker who duped them that they have 6 buyers already waiting to buy their property. I digress.
Anyway, thanks again for your comment and please keep it coming. Happy holidays
Posted by Paphos Properties
Thu Jan 8th, 2009 09:50 AM
Great post, very insightful. There are a lot of clues to pick up. I am certainly picking up something from here like the rest.
Posted by Fiesterdesk
Tue Jan 13th, 2009 02:12 AM
I think you are thinking like sukrat, but I think you should cover the other side of the topic in the post too...
Posted by links of london
Wed Jul 7th, 2010 02:42 AM
You really made some good points in your post