Credit worries in context

The financial world is coming to an end! Not yet. Some analysts have switched their rosy views to one of gloom in a relatively short period, so it is important to focus on the facts and then determine what the markets are telling us.

The best way to look at the credit worries is through spreads. The spread is the added premium above the risk free rate that buyers need to be properly compensated for the risk that they take on. The spread can also be used to infer the probability of default. Two spreads that provide good insight on the markets are long-dated (10-year maturity) BBB-rated corporate and swaps spreads. BBB-rated corporate bonds provide information which is on the cusp between investment grade and high grade. They will be highly sensitive to changes in risk perception for investors who may think there is a change in the credit environment. A decline in these credit ratings may push it into high yield which in some cases cannot be held by some funds. The swap spreads provide information on banks and other financial institutions which are highly sensitive to changes in liquidity and credit risk.

Corporate credit and swaps spreads with 10-year maturities for the period 1990 to the present serve as a good historical review. It is noticeable that spreads will move with the business cycle. When there is a business slowdown, the credit worthiness of companies will decline. Hence, spreads widen. The spreads will also change with specific event risks such as the LTCM crisis and the 9/11. These uncertain events will increase the credit risk of companies.

An examination of the spreads shows that there has been an increase credit risk, but we are not near the highs for the last seventeen years. The top figure shows 10-year swap spreads since the 1990. The second figure shows 10-year BBB corporate yields relative to 10-year Treasury rates as well as the difference in rates, the spread. It could be we have just started the crisis, although the sub-prime credit problems were obvious for the last six months. Nevertheless, it is early to say that this will be a larger credit risk event that what we have seen in the past. It is natural for spreads to increase and they may have been low by historical standards in the case of swaps. A spread increase seems to be a normal part of the changing credit horizon. Slowdown in economic growth as well as specific credit event problems are the cause of these changes. The problem is always with the perception of investors. If the expectation was that credit spreads were stable and would not see large changes, more leverage could be employed. If this stable scenario proves wrong, there are problems.

But what is the key issue for many companies borrowing in the debt market? The overall level of rates, the combination of the risk free rate and the spread is what borrowers have to pay. When looked at from this perspective, the credit spread issue is not yet a problem. The decline in treasury rates has actually offset a large portion of the spread increases so the cost of borrowing on an absolute basis has not changed. Nevertheless, the response in the credit markets has been swift. The amount of new bond issues has fallen like a rock this month. While this is expected with spread widening, it also suggests that investors do not want to lock in debt at current spreads.

Investors must be expecting higher spreads in the future, so they are waiting for something better before committing funds. This is the most relevant information. The spreads will continue to widen until the market perceives that they will not. The pain will be felt by those who anticipated a stable market. This is not a novel prediction but suggests that expectations are still the driver for most financial markets. We are only at the beginning of this credit event.