CDS Spreads Are Narrowing; Recovery Up Ahead?

by: Calafia Beach Pundit

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Credit spreads are very important measures of the economy's health, as I've been emphasizing since last October. At that time, a significant decline in swap spreads (a highly liquid proxy for AA bank credit risk—here's a basic primer on what they are) was one of the very first signs that the worst of the credit crisis had passed. The decline in swap spreads has consistently led the decline in other credit spreads, and declining swap spreads have done a pretty good job of foreshadowing improvements in the overall economy.

Swap spreads came back down to a semblance of "normal" in May, but as these charts show, other credit spreads still have a ways to go. It might take another year for these spreads to come back down to normal. Still, these spreads are making downward progress, and that is essential if the economy is to be on the road to recovery, as it appears it is.

Elevated spreads are a sign that the market is fearful of default risk, and default risk is typically high during recessions for obvious reasons (e.g., money is expensive, cash flow is hard to come by, demand is weak). But with the economy on the mend, money very cheap (banks can get money from the Fed to support lending for almost nothing), and no sign of a general decline in prices, actual defaults are likely to be less than the market is expecting.

That in turn implies that high yield bonds and emerging market bonds (where rising commodity prices have dramatically improved the outlook for cash flow), are still attractive investments. High spreads mean relatively high yields, and declining spreads mean rising prices or better price performance relative to Treasuries.

Disclosure: I am long HYG, EMD, and PAI at the time of this writing.