CDS Spreads Are Narrowing

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Another update on this measure of corporate default risk. This chart shows the spreads on generic, 5-year credit default swaps, a proxy for the level of default risk associated with the 5-year debt of companies rate investment grade and below investment grade (junk). Corporate bonds have enjoyed fabulous performance this year as spreads have plunged. The import of all this is that the market is realizing that the economic outlook is much brighter now than it was at the end of last year, and thus the likelihood of defaults is much lower.

Easy money also has played a role here, since easy money greases the cash flow wheels and makes it easier for borrowers to service their debt. Even with the huge decline in spreads, however, they remain at levels that in the past would have been consistent with a recessionary environment. So the message of spreads is this: at the end of last year, the market was expecting nothing less than a true economic calamity to occur; now it is merely expecting a nasty recession.

This next chart shows the difference between investment grade and junk spreads. This too has declined hugely, but remains at levels that in the past would have signaled considerable economic distress. If you think that the prospects for an economic recovery are at least decent, then corporate bonds still offer attractive valuations

It is very important for equity-oriented investors to pay attention to corporate credit spreads. Analyzing default risk is different from stock-picking, to be sure, but in the end corporate bonds and stocks are part of the same capital market. You can't have one priced to a fabulous outlook for the economy without the other largely in agreement. In this case, while the pricing of corporate bonds has improved dramatically, they still reflect an unusually high degree of risk and uncertainty. I think this gives us a strong clue that equity market pricing is definitely not overly optimistic and most likely very cautious if not cheap. There's still a lot of bad news priced into stocks and corporate bonds.