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Lessons from Credit Spreads

An army of market watchers around the world spend a lot of time predicting market direction. Some follow the fundamental approach and base their views on things like earnings growth of corporates, P/E multiples etc; while some follow the technical approach. The latter express a view on market dirrection by reading charts. They talk support, resistances, head & shoulders, negative and positive divergences etc. While neither of the methods are per se ‘wrong’, it would be rather intuitive to learn about movements in one asset class by looking closely at what happens in another asset class. Credit Spreads is one such ‘indicator’.
Investors in ‘Junk’ bonds - bonds issued by companies that are teetering on the brink of disaster are classified as ‘junk’ - need to be compensated adequately for assuming higher risk by investing in the junk bond as compared to investing in a government backed Treasury Bond. So they demand a higher yield for investing in these bonds. The difference between the yield on a ‘Junk’ bond and a Treasury Bond can be termed as a ‘Credit Spread’.
Credit Spreads and Equities High spreads indicate that risk-appetite among investors is very low. Low spreads indicate the opposite. When investor appetite for risk is low, they tend to invest most of their money in ‘low risk’ bonds. Less money flows into equities and hence, equity markets tend to stay depressed. When risk appetite increases, investors shift money out of debt and direct them towards higher risk asset classes like equities. Result? Equities start rallying. As a consequence, changes in conditions that lead to changes in investor risk appetite…lead to gyrations in equity markets!
Lessons from History In 2003, something led to a contraction in Credit Spreads…and a rally in equities! (Chart helps! Data from Oct-03 to Jul-07)
Low interest rates led to a boom in lending. Corporates re-leveraged their balance sheets enhancing returns for equity holders. Something else also occurred during this period that led to a surge in lending. Private Equity. The LBO (Leveraged Buy-Outs) wave reared its head once again with returns that caught the attention of even conservative investors like pension funds. Demand picked up so much that lenders found it extremely lucrative to lend to the ‘sub-prime’ segment. For a while, returns from these investments far outweighed the inherent risks, as a sub-prime market collapse seemed unlikely. Attracted by the huge returns that these funds were generating, more money started moving out of low risk asset classes…

...Leading to a contraction in Credit Spreads (refer chart). The equity market reacted after a while and the rally began…taking the S&P 500 from 800 to over 1500 levels in the next four years.
The needle that burst the bubble eventually came in the form of higher interest rates and housing market slowdown. The string of interest rate hikes instituted by the Fed, gradually resulted in rising defaults on home mortgages. Rising defaults led to slowing household sales…leading to drop in house prices…leading to more defaults as people found the prices of their properties dropping and buyers hard to come by!

The sub-prime market blew up as a consequence of the housing market slowdown. As the risk of defaults increased, the effect was seen in the credit spreads…which started widening sharply since Jun-2007 (refer chart). Investors, burned by the meltdown, moved into low risk asset classes. Where was the equity market correction?

Current Scenario?
Credit spreads have widened sharply over the past few months after bottoming out at historic lows, but the equity markets, as usual, haven’t begun their reaction. I think the lure of higher premiums for equity by private equity firms is supporting the current rally in equities. On most occasions, equity markets have lagged the developments in Credit Spreads and this time seems no different. If history repeats itself (again!), it wouldn’t surprise me if the equity markets corrected in the short-to-medium term.
As usual, time is one’s best friend…or worst enemy!

Comments

Abhilash said…
By far the best written by the writer on Credit Markets
ilanit said…
Private equity firms generally receive a return on their investments through one of three ways: an IPO, a sale or merger of the company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from Los Angeles business investors to create a capital pool.

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