What Corporate Yield Spreads Are Telling Us About Equities

Despite the government’s best and varied efforts to address the credit crunch, the average yield spread on medium-grade (“Baa” or “BBB”) debt obligations stands at a record high of 642 basis points against a comparable (1962-2008) average of 188 bps. Have corporate bond spreads peaked? And, must bond spreads peak, and trend decisively towards the 40-year average, before a bottom in equities can be called with a degree of conviction?

 

According to a brief analysis issued by the Bespoke Investment Group on Wednesday, there are at least three instances (in 1971, 1974 and 1982) when the S&P 500 bottomed well before bond spreads peaked. The Bespoke analysis cites one example (late 2002) when bond “spreads peaked at the same time as the S&P 500 made its low”.

 

But history provides no guidance in today’s unique and unprecedented financial and economic environment. There is every reason to believe that, this time around, corporate bond yield spreads will not approach anything close to the 188 bps average at all. In fact, this writer’s bearish call on equities (DIA, QQQQ and SPY) is, in good part, based on the assumption that the very sustainability of the historically high spreads is eroding the foundation of equity valuations.

 

For starters, the quality of the benchmarks themselves is now in question, as credit default swap spreads for 5-year and 10-year US treasuries settle above 60 bps, in preparation for a move into the 80s as the $8 trillion-plus bailout saga unfolds over the next two months. Secondly, it is obvious from the post-September behaviour of the CDX and iTraxx high-yield indexes that the average yield spreads on corporate bonds today would be closer to 850-900 bps if it were not for systemic-risk-offset actions taken by the Treasury and the Fed.

 

Thirdly, sophisticated lenders are now rationalizing yields after taking into consideration the cost of default insurance on institutional and corporate borrowers; in this regard, before on gets to the corporate spectrum, it should be noted that CDS spreads even for government bailout targets in the US and in Europe are at levels nobody could forecast a few short months ago. For better of for worse, CDS spreads for ex-blue-chip names like Goldman Sachs (340 bps), Morgan Stanley (440 bps), Citigroup (250 bps), UBS (205 bps), Credit Suisse (185 bps) and Deutsche Bank (140 bps) are having a direct impact on determining corporate bond spreads.

 

Finally, there is this rather complex issue of rating downgrades in a climate where it is evident that the leading rating agencies are overwhelmed by the task at hand. As was more than obvious in this week’s downgrades for Goldman Sachs and Morgan Stanley, and rating cuts for a number of sovereign issues, the best the rating agencies can do now is to follow the news. Since, early warnings, as opposed to after-the-fact announcements, are now well in the past, uncertainties surrounding the fate of certified credit quality are also playing a significant role in keeping bond yield averages at 40-year highs.

 

In summary, this writer’s stance is that the bond-yield-spread matrix has undergone an irreversible transformation; despite some excellent analysis on yield-to-equity correlations and breakouts being provided by Bespoke in recent weeks, history is certainly not repeating itself. On the contrary, what the matrix is telling us is that when fundamental cost-of-capital and debt-equity relationship considerations are applied to the corporate spectrum, a significant decline (20%) in equities is overdue.

 

Perhaps we may have to wait (a) for the market to acknowledge the limited effectiveness of the stimulus packages being proposed by the new administration before we see the S&P 500 at 700 and lower, and (b) for investors to realize that the finger-in-the-dyke Dutch legend, which Ben Bernanke and Hank Paulson are currently applying to systemic risks, was actually an all-American literary invention, not historical fact.

 

 

 

 

 

 

Tags: arbitrage, Bonds spreads, equities, noninvestment grade, S&P 500