Keep An Eye On Bond Spreads

What is the divergence in the performance of equity and corporate bond ETFs telling us?

At yesterday’s (1 July) intraday low, the S&P index had fallen 17% from its end-April peak. In Europe, the Euro Stoxx 50 price index’s closing level yesterday, 2519, represented a decline from the year closing high, 3013, set on 15 April, of almost the same percentage.

Yet while equities are entering bear market territory, corporate bonds are sailing blithely on.

In Europe, for example, the largest corporate bond ETF, iShares’ iBoxx euro fund (IBCX), is very close to its all-time highs, as the chart below shows.

The ETF’s performance chart doesn’t tell the whole story, however. There has been some widening in corporate bond spreads during recent weeks, which has been disguised in the performance of iShares’ corporate bond ETF by the simultaneous drop in government bond yields. The yield spread of the Markit iBoxx € Liquid Corporates index, which IBCX tracks, has recently moved back up by around 50 basis points from its best levels of early January and late April.  See below.

All the same, yield spreads are nowhere near the distressed levels reached in late 2008 and early 2009. A large part of the reduction is due to the decline in banks’ bond yield spreads as a result of government backstopping of their balance sheets (IBCX has a 41% weighting in financials). With sovereign credit risk itself on the rise and the value of this government guarantee no longer as solid as it was, this symbiotic (or should I say parasitic?) relationship between banks and treasuries is under strain.

But, for the time being, those expecting equities to fall substantially further may have to wait for corporate bond spreads to widen first. Or, putting an optimistic slant on it, if spreads stay where they are then equities may start to attract demand again after the sharp sell-off of the last two months.

The longer-term outlook for corporate bonds is less clear. We’re looking at a record low rate of high yield bond defaults in the US for 2010, according to Fitch (log-in required to read the report), a surprisingly positive outcome given the severity of the 2008/2009 downturn.

However, as economist Andrew Smithers argues in a recent report, low current and historical default rates are unlikely to be a good guide to the future, since they represent the outcome of decades of implicit government insurance of financial markets. With public debt issuance probably approaching its limits, the ability of states to bail out the private sector is diminishing, implying a rise in company failures from here.

Whichever way things go, corporate bond yields and their implied spreads over government bonds bear close attention, for equity as well as fixed income investors.

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