Corporate Bond Yield Spreads - Unbelievable!!!

RGE: The comparison of cash bond and CDS indices shows that the real action in corporate credit markets is taking place in the cash bond markets, in both the investment grade and the high yield segments. After Lehman’s default, a heavy selloff in both investment-grade and high yield bonds took place that sent cash bond spread higher than their CDS counterparts (‘basis’ definition = CDS spread – asset swap spread rather than bond spread, but results are similar) in a reversal of fortunes since the start of the credit crisis. A negative basis used to be common in the good old days when the building up of leverage in structured products required the sale of large amounts of credit protection. The unwinding of these structures instead sent CDS spreads higher than cash bonds during the crisis. Until mid-September.

Going forward, will bond yields eventually converge lower as investors take advantage of distressed prices and arbitrage opportunities (negative basis trade includes buying both a bond and protection on the same to lock in risk-free profit)? Or are bond prices reflecting a fundamentally worse outlook that is not captured in CDS spreads?

It depends on the reasons for the jump in bond spreads. Market commentators offer two explanations:

1) deteriorating credit quality;

2) technical bond demand and supply factors.

Overview:

Graph 1: iBoxx $ Domestic Corporates AAA Spread to Libor (white) VS. 5-year Investment-grade CDX Spread to Libor (orange)

From EIU: Better-quality investment-grade corporate bonds (company bonds rated triple-A to triple-B) suffered negative total returns of more than 7% for a second straight month in October. This is an astounding development. For Merrill Lynch indices dated back to 1989, there had not previously been a loss in excess of 4.25% in any given month, let alone a loss of more than 14% on a two-month basis (see Graph 1)

For high-yield or “junk” bonds (company bonds rated double-B or lower), the loss was more than 16% in October alone, after a more than 8% loss in September. Each, at the time of release, marked a record monthly loss for the category (see Graph 2.)

Graph 2: BLP Active High Yield US Corporate Bond Price Index (orange) VS. 5-year High Yield CDX Price Index (white)

The reasons for this sell-off are twofold:

1) Deteriorating Credit Quality:

The high-yield market is entering the up-leg of the default rate cycle with a far worse credit quality mix than the last time around. In particular, as a percentage of the total high-yield universe, triple-C issues ended October 2008 at about 27% of the total, a record high for the index and up about five percentage points year on year. During the last credit cycle collapse in 2001-02, the triple-C share topped out at less than 25% in the fourth quarter of 2001, presaging the looming default cycle well into 2003.

Graphs 3 and 4 compare the share of low-quality debt (B3 or lower) and defaults in previous cycles. The results are stunning.

Graph 3:

Source: Moody’s

Graph 4:

Source: Moody’s

Fitch says in a recent report that, including bonds affected by Lehman Brothers’ bankruptcy filing and Washington Mutual Inc.’s collapse, the par value of corporate bond defaults exceeds $100 billion already, a level comparable to 2002 when total default rates reached over 12%. In October, Fitch warned of the worst default rate on record in this cycle. Currently, high yield spreads imply a default rate of nearly 21% (see Graph 4) while corporate downgrades have been accelerating in Q3. In other words, what is investment grade today may soon not be anymore as the economy worsens. Moreover, commercial paper funding conditions remain tight.

2) Technical Demand and Supply Factors in the Corporate Bond Markets:

Among the major factors which have caused these steep price drops in the bond markets are the heavy selling volume on behalf of hedge funds and other institutional investors in need to raise cash to meet liquidations requests, margin calls, and deleveraging pressures. An additional factor is sheer risk aversion with investors shifting out of risky assets into safe Treasuries (see Graph below)

Graph 6:

So are these firesales indicating the presence of buying opportunities? Kiessel from PIMCO is cautious. “Now, with credit spreads at all-time wides, we are more positive on credit valuations, simply from the standpoint that investors are finally getting paid now to take selective credit risk. Nevertheless, the real effects of the credit crunch will be felt throughout the overall economy over the next year, and near-term deleveraging is likely to continue with near-term negative market technicals with more risky bond sellers than buyers.”

p/s photos: Jiang Yu Chen

US Treasury Yields Near Zero

WASHINGTON - THE panic in global financial markets has sparked an unprecedented rush into safe US Treasury securities, driving yields on short-term government notes down to almost zero.

Due to stampeding demand for safe short-term investments, the US Treasury's four-week and three-month bills on Friday yielded an effective rate of 0.01 per cent - down sharply from 1.515 per cent and 1.785 per cent, respectively, in early September.

Other Treasuries are also showing record low yields. The 10-year bond yield fell as low as 2.505 per cent and the 30-year bond yield slid to 3.005 per cent at one point on Friday. The six-month bond yielded a mere 0.20 per cent.

The low yields reflect a surge in demand for these instruments, seen as the safest in the world during times of turmoil.

'Investors seem to be content to sell stocks and park into the bonds for now,' said Mr Greg Michalowski of the financial website FXDD.

Analysts say the fear factor has pushed up demand for Treasuries, since investors are virtually certain the US government will not default.

Other factors include worries about deflation and the overall trend in interest rates, with the Federal Reserve having cut its base lending rate to a historic low of 1.0 per cent, and further reductions possible.

But Mr Bob Eisenbeis, analyst at Cumberland Advisors, said the unprecedented low yields are a sign of 'dysfunction' in markets.

Eisenbeis said US municipal bonds are paying upwards of 6.0 per cent tax-free and corporate bonds even more, but that fears of default and a lack of knowledge about underlying bond quality have led investors to shun these alternatives.

One reason for the surge in demand for Treasuries, said Mr Eisenbeis, is the Federal Reserve's decision to flood financial markets with liquidity including through other central banks.

Many central banks and commercial banks are reluctant to use this cash for traditional lending, and are buying Treasuries to ride out the storm, Mr Eisenbeis added.

A big question for the market is whether the Treasury market has become a bubble that will burst.

Although the low rates allow Washington to borrow money cheaply, Mr Eisenbeis said such a scenario could be perilous for the economy and the dollar.

'When you have this huge flood of liquidity into the marketplace, that can't last forever,' he said.

A bursting of this bubble could mean a rush out of Treasuries, forcing the government to pay higher rates on an unprecedented amount of debt.

'We would have huge increases in our costs and people wouldn't want to hold Treasury obligations anymore because of the capital losses,' Mr Eisenbeis said.

'You could have a huge switch in interest rates very quickly.' Mr Mike Larson, an analyst at Weiss Research, says the long-term bond market could be 'the biggest bubble of all', worse than the dot-com and real estate bubbles.

'Treasury bonds almost never move this far, this fast. And interest rates, which move in the opposite direction of bond prices, almost never fall this far, this fast,' Mr Larson said.

Mr Larson said the yield on the 10-year Treasury bond plunged from a mid-October high of 4.08 per cent to nearly 2.5 per cent this week, 'yielding lows not seen since the mid-1950s'. 'There are lots of reasons to believe this Treasury rally is unsustainable, and that a day of reckoning is fast approaching,' he said.

Mr Sal Guatieri, economist at BMO Capital Markets, acknowledged that 'investors are throwing money at Uncle Sam with the same conviction that they bought houses and dot-com stocks in their heydays'. But he argued that if inflation is quashed and investors retain confidence in the US government, the dangers have not yet hit a boiling point.

'While Treasuries may be overpriced, they probably are not yet in a bubble,' he said.

Comments: The continued buying of US Treasuries indicates a few major conclusions:

a) the aversion to corporate bonds, the risk in corporate defaults is still high

b) the aversion to risk is very high, many are willing to accept 0% yield to be in USD

c) that the markets are unconvinced on the measures promoted by the government so far

d) the anticipation of more major corporate collapses, and maybe even more bailouts to come

e) the aversion to stocks of any kind, even US stocks, hence we are seeing no flow of funds to emerging markets for now

f) the zero yield is the most important indicator that financials and credit markets are not working properly

g) corporates will have enormous difficulty to raise funds or even renew their funding

h) the pressure has mounted significantly for governments to do a lot more to unfreeze credit markets

i) this will cause most companies to hoard cash rather than reinvest, in other words companies will be cutting back operations and capacity further, a priority will be to push down inventory

j) If investors are willing to hold zero yield Treasuries, its a telling sign that people want to be in CASH but not in a bank as they do not trust their money within any banks

doraiddd has left a new comment on your post "US Treasury Yields Near Zero":

k) this notion that us treasuries are also the safest asset class to be in will be soon proven to be the ultimate fallacy... and fantasy...

l) us treasuries are the last remaining asset bubble left. Expect the chinese, arabs and the japanese to unload soon....

m) when the panic stampede starts outta us treasuries, where u gonna hide? where u gonna run? who's gonna save you??

n) maybe perhaps king midas himself...?


Expect a trying week for stock markets globally. Not a nice way to end 2008.

p/s photos: Zhou Wei Tong

Corporate Bonds Spreads & Good Economists

Han Qiang said...

he mentioned 2 important points which i think you might have missed out. The spread between corporate bonds and treasuries remain elevated. CDS indices for investment grade remains high despite falling libor-ois and ted spread.

I verified his statement and realise that bonds spread remain high even for AAA-rated corporate bonds. This is significant because this suggest not only the third tier companies will be defaulting.

my 2 cent worth

10:28 PM

Comments: Fair comment. In a normal rational market, when spreads btw Treasuries and corporate bonds start to widen, its a sign that risk of default is higher and a likelihood of an imminent big correction in the stock markets because investors are pulling money out of corporate bonds, or demanding higher rates to hold them. To see them now, after all the injections of liquidity and after such a huge correction, seems to me its not rational investing. Investors are still demanding higher yields on corporate papers, not so much that they might default (still a risk) but rather to the ability of these companies being able to refinance the bonds when they are due, and also the volatile market situation which makes everyone fly towards Treasuries. The spreads is more a reflection of risk aversion rather than a telling sign on future defaults. The spreads have widened even more on junk bonds, and rightly so as they will be the first to default, and first to find it much harder to get new funding. Hence, your conclusions would be more correct in a normal functioning, pre-correction market... maybe not so much now.

Kris said...

The most important of all for Dr.Doom is that did he made serious money shorting the market when he predicted the October 2008 fall?

Talking is one thing..doing is another..lol :P

11:34 PM

Comments: That is not a fair comment. We all have a role to play. Some are good analysts, some are good economists, some are good portfolio managers. We cannot and should not judge by how much they make before terming them as good experts or poor ones. Some good economists may be poor traders and poor stock selectors. Roubini did very well in his predictions, let's just say that. No need to see whether he made his money or not. Same for some portfolio managers and traders who made money but are piss poor when it comes to analysis. If money is your be all and end all, so be it. Then we will end up worshiping bank robbers who got away, or unscrupulous corporate executives who bilked companies out of millions and still not prosecuted, are these guys your heroes?

The Standard HK: Tuesday, November 04, 2008

Are you depressed about all the money you've lost during the market downturn?

Well cheer up, because even an expert like Stanford University economics professor and Nobel laureate Kenneth Arrow didn't know enough to pull his money out before the market crash.

Arrow, who in 1972 became the youngest person ever to win the Nobel Prize in economics, was in Hong Kong yesterday to deliver the Sun Hung Kai Properties Nobel Laureates Distinguished Lecture at Chinese University.

Arrow later said he has suffered an investment loss of 30 percent during the financial crisis.

p/s photo: Nia Ramdhani