St. Louis Fed: Series: WBAA, Moody’s Seasoned Baa Corporate Bond Yield
Series: WGS10YR, 10-Year Treasury Constant Maturity Rate
According to the latest data from the Federal Reserve, Baa corporate bonds are yielding 4.56% more than 10-year Treasuries. The chart below shows this relationship over the last 40+ years.
The spread between the return on 10-year Treasuries and Baa-rated corporate bonds was 336 basis points last week. In historical terms, that is very high. In fact, the only times in the last 50 years that it was higher were the trough of the tech wreck and the 1982 recession/stagflation busting cycle.
High credit spreads make it harder for corporations to borrow and invest. As spreads widen, the economy tends to slow.
For investors, however, high spreads represent additional potential returns for a given unit of risk-taking. Peak levels of risk premia typically precede strong returns on risky assets - even if the strong returns are short-lived, as was the case in 2003.
Spreads have hooked down slightly as the credit woes that peaked following the Bear Stearns (BSC) debacle may finally be stabilizing. Time will tell whether that was “the” peak or whether the current easing is simply a lull.
Regular readers know I follow the spread between Baa-rated bonds and Treasuries to get a feel for how much they are willing to accept risk.
Last week, as the market rallied on the initial news of the JP Morgan (JPM - Annual Report) and Fed-led rescue of Bear Stearns (BSC) I said “The big questions are whether, how much, and how quickly the spreads will begin to narrow again. That will be the real signal from bondholders that the worst is behind us from the current crisis.”
Instead, credit spreads continued to widen. They averaged 343 basis points last week, up from 340 in the prior week.
It remains a double-edged sword. As long as the spread continues to widen, risky assets will perform poorly. However, the abnormally high risk premia we are currently seeing indicate that longer-term investors will be paid more handsomely for accepting such risks than they have been paid on average in the past.
Regular readers know I follow the spread between Baa-rated bonds and Treasuries to get a feel for how much they are willing to accept risk.
Right now, it is not much.
Last week the spread widened to 340 basis points, a level seldom seen over the last 50 years.
Of course, we knew that already. The big questions are whether, how much, and how quickly the spreads will begin to narrow again. That will be the real signal from bondholders that the worst is behind us from the current crisis.
It is something of a double-edged sword. As long as the spread continues to widen, risky assets will perform poorly. However, the abnormally high risk premia we are currently seeing indicate that longer-term investors will be paid more handsomely for accepting such risks than they have been paid on average in the past.
According to the Federal Reserve, the spread between the interest rate paid on Baa-rated corporate bonds and the 10-year Treasury continued to widen last week, to 311 basis points. The spread has seldom stayed above 300 basis points for very long, going back to 1962.
Over the last 10 years, the Internet bust caused a couple of such spikes.
As long as the spread continues to widen, risky assets will perform poorly. However, the abnormally high risk premia we are currently seeing indicate that longer-term investors will be paid more handsomely for accepting such risks than they have been paid on average in the past.
I follow the spread between BBB (the highest investment grade) corporate debt and Treasuries as a gauge of overall investor willingness or unwillingness to accept risk. Lately, investors have been less and less willing to accept risk, plowing money into Treasury bonds and lowering their yield.
The spread is now 296 basis points, which is close enough to my 3% trigger to call this an “official” crisis. Such events tend to happen only once or twice per decade. As a general rule, they have typically signaled good times to be in risky assets such as stocks.
I often take the pulse of risk tolerance by looking at the corporate/treasury risk premium, which is calculated on a daily, weekly and monthly basis by the Federal Reserve. (Specifically, I compare the Baa Corporate bond rate to the 10 year Treasury Constant Maturity.)A lower spread is positive for the economy and for corporate earnings, as it means companies don’t have to pay as much (relative to riskless treasuries) to borrow money that can then be invested in profitable opportunities. In effect, it lowers the bar as to what makes for a worthwhile investment. A low spread has a mixed message for stock market investing - good for earnings/economy per above, but means investors are being paid less to take risks.
The current spread is nearly as high as that of the 1998 Russia/LTCM crisis. The truly big investing opportunities (the telecom bust, the 1987 crash) usually offer spreads above 300 basis points.
Note:
Make sure to look over the credit card offers that come in the mail for the best card deal!
The risk premium between investment grade corporate bonds has widened, resulting in the largest rewards for those willing to accept default risk since mid-2003. The spread is nearly as wide as it was during the 1998 Russia/LTCM crisis.
That is not to say it is a good time to buy risky assets, but it does indicate that the likely payoff for doing so is higher than normal.
Risk premia are the extra returns investors want to receive in exchange for taking risk. There are many types of risk premia, including:
Some of the risk premia are hard to measure, but based on observation I have noticed that many are correlated. Investors not wanting one type of risk often don’t want any kind of risk. As a result, I often take the pulse of risk tolerance by looking at the corporate/treasury risk premium, which is calculated on a daily, weekly and monthly basis by the Federal Reserve. (Specifically, I compare the Baa Corporate bond rate to the 10 year Treasury Constant Maturity.)
A lower spread is positive for the economy and for corporate earnings, as it means companies don’t have to pay as much (relative to riskless treasuries) to borrow money that can then be invested in profitable opportunities. In effect, it lowers the bar as to what makes for a worthwhile investment. A low spread has a mixed message for stock market investing - good for earnings/economy per above, but means investors are being paid less to take risks.
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