The Credit Spread

Credit Bubble II

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CreditPulse
As the graph shows, the credit spread first moved into danger territory on Jan. 20 where it has stayed for most of the past four months.

The credit spread, a key liquidity and macro economic indicator that represents the difference in yield between high-risk junk bonds and the low-risk 10-year treasury bond, is once again below the critical 3 percent mark.  "They're overlooking the risk."

In the May 2008 issue of Fortune magazine, Harvard trained economist Geoff Colvin wrote that June 13, 2007 was the day that the markets "rediscovered risk."  June 13th was notable as the day that years of excess liquidity, which had fueled a cavalier attitude toward risk taking, rapidly began to dry up spawning the largest credit crisis since the Great Depression.

Just before the crisis, the credit spread had reached a mere 2.4 percentage points.  In other words, the gap between the interest earned by investors investing in junk and the interest earned by investors investing in treasury bonds was a mere 2.4 percent.  The problem?  The risk spread between those two investments was a lot more than 2.4 percent.

As a result, the credit spread is an important liquidity and economic indicator to watch because it shows the balance or imbalance that exists in the all-important risk versus reward relationships that are central to the concepts of credit risk and free market capitalism.  It also is an indicator of the influence that market forces have on resource allocation, another critical component of capitalism that is garnering more attention in the news (see Noteworthy, CP frontpage).

As of May 20th, the credit spread stood at 2.69 percent based on the difference between the 10-year treasury yield of 3.15 percent and a junk bond yield as measured by the Merrill Lynch High Yield 100, published daily in the Wall Street Journal and tracked by CreditPulse, of 5.84 percent.  The spread first dipped below the 3 percent level in January of this year for the first time since the last week of April of 2010 when it reached 2.999 for only one day.

The narrowing of the spread in the past four months is due largely to a huge drop in junk bond yields, which means the price has been rising due to more attention from investors.  Yield and price run in opposite directions.

For the month of December 2010, the average yield for the Merrill Lynch High Yield 100 index was 6.75 percent.  So far in May, the average is 5.915 percent for a decrease of .835 percent.  Little wonder since last week, the Financial Times, The Wall Street Journal and other media outlets reported that junk bond sales from risk companies set a new record of $56 billion.  

The Financial Times article does not mention the credit spread but it did report that average yields on junk bonds had fallen to a new low of 6.64 percent as reportedly indicated in the Bank of America Merrill Lynch Index, according to the article.  That is higher than the 5.84 percent yield in the Merrill Lynch High Yield 100 as reported by the Wall Street Journal but much lower than the 7.7 percent junk yield in June 2007, just before the crisis began, as reported by Colvin in his May 2008 article.

To illustrate just how things are getting out of hand, consider the decision last month by Andrew Smock, co-chief investment officer at Merganser Capital, to sit out the $1.25 billion bond offering by Ford Motor Credit, the lending arm of Ford Motor Company, according to a May 8th article that appeared on msnbc.com.  Although Ford was the only Detroit car maker not to receive a U.S. government bailout it came awfully close as its balance sheet was only slightly better than General Motors'. 

Yet in spite of the investment risks, the Ford bonds were offering a yield of only 5 percent annually over seven years, according to the article.  In August 2009, a Ford Motor Credit bond issue carried a yield of 10.875 percent, according to research done by CreditPulse.  "Ford isn't necessarily the poster child of junk," said Smock, "but you're not being paid enough for the risk."  Not too long ago, super-safe Treasury notes of similar maturity to the Ford bonds were yielding the same 5 percent.

Even money managers that are huge proponents of junk bonds and its impact on the economy such as George Cipolloni, co-manager of Berwyn Income, a mutual fund that holds junk, are offering a word of caution: "People are more desperate for yield than they are fearful of losing principal," Cipolloini told msnbc.com.  "They're overlooking the risk."