Bond Outlook: A Warning About Taking Credit Spreads at Face Value

by: AllAboutAlpha

Once upon a time, investors and market-watchers alike could look to the bond market for indications of where the broader economy was headed. So the bond market went, so went the economy – at least somewhere around 50% of the time.

More recently, though, that correlation has gone to the birds thanks to a variety of factors, most notably unprecedented fiscal stimulus, zero interest rates and uncertain prospects for some sort of “normal” recovery from the Great Recession.

All the more reason why a report from Standard & Poor’s (click here to download) released just before the holidays seems apropos to focus on – not only from a hedge fund and alternative investment perspective, but from a where-is-this-crazy-market-going vantage point.

The report takes to task what many financial market participants and observers are now trying to figure out, especially given the increased focus on credit strategies of late and new-found interest in trying to gauge when interest rates at zero are eventually going to go up. Do credit spreads measure credit risk?

On the surface, one might be forgiven for being dismissive in providing the seemingly obvious answer of yes. After all, as noted above and as many still regard, bond market yields generally provide signals as to where both interest rates and the economy are going.

However, according to S&P’s findings, that actually isn’t true. On the contrary, while tempting to read into what price signals from bond and credit default swap (CDS) markets might suggest, fundamental credit analysis and interpretation of market fluctuations and prices are the more reliable ways to figure things out.

"Unlike fundamental credit analysis, market prices provide neither diagnostic capabilities nor insights into the reasons that differentiate one company’s credit standing from another’s,” the report says. “Markets capture investors’ emotions with great speed and efficiency and, consequently, can overreact to headlines, creating excessive volatility. Moreover, a great deal of evidence indicates that securities pricing is vulnerable to market illiquidity, unreliable information, asymmetrical information, investor herding, and differing investing and trading strategies.”

In other words, maybe you can get a bit closer to figuring out where stocks are going to open by watching equities futures, but you aren’t necessarily going to get further ahead in the credit markets by watching yields or spreads, especially if those spreads are related to a product with an acronym like CLS, CLO, or CDO.

Even before the market meltdown, credit spreads weren’t necessarily the panacea tealeaves in the pot. Indeed, because so much cash was chasing too few investments, bond and CDS spreads ended up falling to never-before-seen levels, which in hindsight were not realistic barometers of risk.

For example, high-yield ‘B’ rated bond spreads fell from 700 basis points (bps) over U.S. Treasuries in 2003 to about 200 bps in 2007 – about the same spread at which ‘BBB’ rated bonds had been trading at in 2003. (See chart below.) By comparison, the average ‘B’ rated bond today trades at about 600 bps over U.S. Treasuries.

In short, basic supply and demand fundamentals distorted pricing with little regard for credit quality, leaving the illusion of liquidity when there may not be any, or perhaps less than might be thought.

Further complicating matters in the current environment is the fact that money managers, in particular hedge fund managers and others who are increasingly putting large sums of money to work along the credit structure, are, from S&P’s vantage point, distorting not only how various spread differentials might appear but also altering what the debt of individual companies might be perceived as being worth.

Hedge fund traders, for instance, may have, or believe they have, information about a company or a security that differs from what the broader majority think, which in turn impacts how that security is valued, and in turn how it affects its relationship along the yield curve.

The bottom line from S&P’s vantage point is that there was never a sure-fire way to interpret broader market dynamics by the direction of market activity alone, even more so post-Great Recession, where figuring out what’s going on behind a debt instrument is just as important as figuring out why it’s going up or down.

Seemingly obvious, though helpful to have reminders that what used to work in the good old days of less than 24 months ago no longer work at all.