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.