The Credit Spread

Credit Spread Moves Below 3.0 Percent

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CreditPulse graph
On March 6, 2009, the Dow Jones Industrial Average was at 6,627. Thursday the DJIA closed at 11,144, a 68 percent increase.

Narrowing of credit spread indicates the relationship between price and risk of low-risk government bonds and high-risk junk bonds is once again reaching pre-credit crisis levels.

The credit spread, the yield difference between low risk 10-year U.S. treasury bonds and high risk junk bonds, narrowed to below the critical 3.0 percent mark last Thursday to close at 2.978 percent, according to yield benchmarks tracked by CreditPulse.  The credit spread has now reached its lowest level since 2007, the year before the credit crisis.

The narrowing of the credit spread, sometimes referred to as the corporate spread, is usually an indicator of economic prosperity but when falling too low can also be an indicator of excess risk taking and excess liquidity because it means investors are moving into junk and out of treasuries.  Aiding this development is the short-term Federal Funds rate which has remained at or near zero before, during and after the credit and banking crisis. 

Ann Lee, an economist at New York University and an expert on financial derivatives, told CreditPulse that she thinks the current Fed policy is impacting the credit spread: "[Federal Reserve Chairman] Ben Bernanke has successfully perpetuated casino capitalism.  Since interest rates are so artifically low, everyone has been indiscriminate in chasing yields again, regardless of risk.  It's a very sad state of affairs."   

A shrinking credit spread, particularly below the 3 percent mark, indicates a narrowing of the price gap for widely different levels of risk.  Bond yields move inversely to price.  This is exactly the same thing that happened back in June of 2007 when the seeds for the 2008 credit crisis were sown.  However, at that time, the benchmark yield for junk was at 7.381 percent, .555 percent more than the current level. 

Last week, the benchmark 10-year treasury note continued to rise reaching 3.848 at the close of business Thursday, April 15th, according to Ryan ALM data published in the Wall Street Journal.  Meanwhile, the Merrill Lynch High Yield 100, a prominent junk bond benchmark, decreased to 6.826, according to Merrill Lynch data published in the Journal.

The credit spread, one of the benchmark measurements for the integrity of credit markets, has dropped feverishly since the 10.125 percent spread reached back on March 9, 2009 (see graph above left).  The credit spread reached its widest point on November 30, 2008 during the height of the credit crisis when credit markets had virtually dried up with a spread of 13.728 percent.  On that date, the yield for the 10-year treasury was 2.959 while the junk-bond yield was 16.687.

The 10-year treasury yield has steadily risen since the middle of last year when it hovered around the 3 percent mark largely as a result of Federal Reserve efforts to keep it and mortgage rates low since the treasury yield and mortgage rates typically move in lock step.  Treasury prices, which move inversely to yields, have been under severe downward pressure as the result of the Federal Reserve's massive issuance of new paper to pay for the government's economic stimulus and other bailout programs. 

On the other hand, as the yield on government bonds rises due to falling prices, the yield on higher risk corporate junk bonds is decreasing as prices for those bonds rise as investors gobble up more corporate debt, some of it risky.  The Merrill Lynch High Yield 100 junk bond benchmark has dropped 47 percent since March 9, 2009 from 12.875 percent to 6.826 percent last Thursday.