Continuing a bit from yesterday's post on The Fear Factor (i.e. risk aversion), I calculated corporate credit spreads for AAA and BAA bonds vs. the 10 year Treasury. I then divided these spreads with the yield of 10 year Treasurys, to obtain a ratio of the spread as a percentage of the Treasury's current yield.
This gives us a sense for the "effective" credit spread, i.e. how much upside in income a potential investor gives up by choosing a government bond instead of a corporate bond. It's one thing to give up an extra 100 basis points when rates are 10% and another when they are 5% - the effect is double in the second case. The results are charted below (click to enlarge).
Data: St. Louis Fed
The ratios have shot up faster than ever before and are nearing all-time highs; investors are spurning higher yields and instead seek the safety of Treasury bonds. Return of principal is taking priority over return on principal.
In addition, AAA and AA corporate bonds have become endangered species over the years, as debt replaced equity in balance sheets and overall credit quality deteriorated (how many AAA or AA corporate names can you think of?). Markit's CDX Investment Grade credit default swap index for North America is made up 53% with bonds rated BAA, 42% rated A and just 5% rated higher. This makes BAA bonds a better benchmark for "real economy" credit spreads.
Intra-corporate credit spreads between BAA and AAA bonds vs. Treasurys have also shot up sharply (chart below, BAA yield minus AAA yield, divided by 10 year Treasury yield).
Another sign of risk aversion is the sharp rise in credit spreads for higher-risk corporate loans used for LBOs and such leveraged takeover activity. Spreads for Markit's LCDX index have jumped from 310 bp to 460 bp in less than one month.
Now, there are two ways to interpret the charts: if you are a contrarian, you could say that risk aversion is overdone and will soon recede, resulting in all manner of rallies in financial markets. Or... not.
Personally, I think risk aversion is the new paradigm and will persist. Readers of this blog sporadically report hearing their friends "confessing" they are lowering debt; an article in today's NY Times comes to confirm this:
...But now the freewheeling days of credit and risk may have run their course — at least for a while and perhaps much longer — as a period of involuntary thrift unfolds in many households. With the number of jobs shrinking, housing prices falling and debt levels swelling, the same nation that pioneered the no-money-down mortgage suddenly confronts an unfamiliar imperative: more Americans must live within their means...
...The shift under way feels to some analysts like a cultural inflection point, one with huge implications for an economy driven overwhelmingly by consumer spending.
P.S. December real retail sales in the Eurozone dropped 2% from last year. Biggest declines occurred in Belgium (-6.9%), Germany (-6.7%) and Spain (-1.8%). Is it necessary to point out that Germany is the world's third largest national economy?
P.P.S. The January ISM Non-Manufacturing Index was just released and it was downright horrible: 41.9 vs. 54.4 in December. The index tracks prospects for the service economy, i.e. 90% of US GDP. As a diffusion index, readings below 50 signify contraction and vice versa.
The drop was the largest ever since ISM started publishing the index in 1998.