The comparison of cash bond and CDS indices shows that the real action in corporate credit markets is taking place in the cash bond markets, in both the investment grade and the high yield segments. After Lehman’s default, a heavy selloff in both investment-grade and high yield bonds took place that sent cash bond spread higher than their CDS counterparts (‘basis’ definition = CDS spread – asset swap spread rather than bond spread, but results are similar) in a reversal of fortunes since the start of the credit crisis (see also PAM.) A negative basis used to be common in the good old days when the building up of leverage in structured products required the sale of large amounts of credit protection. The unwinding of these structures instead sent CDS spreads higher than cash bonds during the crisis. Until mid-September.
Going forward, will bond yields eventually converge lower as investors take advantage of distressed prices and arbitrage opportunities (negative basis trade includes buying both a bond and protection on the same to lock in risk-free profit)? Or are bond prices reflecting a fundamentally worse outlook that is not captured in CDS spreads?
It depends on the reasons for the jump in bond spreads. Market commentators offer two explanations:
1) deteriorating credit quality;
2) technical bond demand and supply factors.
Graph 1: iBoxx $ Domestic Corporates AAA Spread to Libor (white) VS. 5-year Investment-grade CDX Spread to Libor (orange)
From Economist Intelligence Unit: Better-quality investment-grade corporate bonds (company bonds rated triple-A to triple-B) suffered negative total returns of more than 7% for a second straight month in October. This is an astounding development. For Merrill Lynch indices dated back to 1989, there had not previously been a loss in excess of 4.25% in any given month, let alone a loss of more than 14% on a two-month basis (see Graph 1)
For high-yield or “junk” bonds (company bonds rated double-B or lower), the loss was more than 16% in October alone, after a more than 8% loss in September. Each, at the time of release, marked a record monthly loss for the category (see Graph 2.)
Graph 2: BLP Active High Yield US Corporate Bond Price Index (orange) VS. 5-year High Yield CDX Price Index (white)
The reasons for this sell-off are twofold:
1) Deteriorating Credit Quality:
High-yield specialist Martin Fridson notes that “the high-yield market is entering the up-leg of the default rate cycle with a far worse credit quality mix than the last time around.” In particular, as a percentage of the total high-yield universe, triple-C issues ended October 2008 at about 27% of the total, a record high for the index and up about five percentage points year on year. During the last credit cycle collapse in 2001-02, the triple-C share topped out at less than 25% in the fourth quarter of 2001, presaging the looming default cycle well into 2003.
Graphs 3 and 4 compare the share of low-quality debt (B3 or lower) and defaults in previous cycles. The results are stunning.
Source: Moody’s via High-Yield Blog
Source: Moody’s via High-Yield Blog
Fitch says in a recent report that, including bonds affected by Lehman Brothers’ bankruptcy filing and Washington Mutual Inc.’s collapse, the par value of corporate bond defaults exceeds $100 billion already, a level comparable to 2002 when total default rates reached over 12% (see Altman paper for in-depth analysis.) In October, Fitch warned of the worst default rate on record in this cycle. Currently, high yield spreads imply a default rate of nearly 21% (see Graph 4) while corporate downgrades have been accelerating in Q3 (see also Fitch 2). In other words, what is investment grade today may soon not be anymore as the economy worsens. Moreover, commercial paper funding conditions remain tight.
2) Technical Demand and Supply Factors in the Corporate Bond Markets:
According to Seeking Alpha among the major factors which have caused these steep price drops in the bond markets are the heavy selling volume on behalf of hedge funds and other institutional investors in need to raise cash to meet liquidations requests, margin calls, and deleveraging pressures. An additional factor is sheer risk aversion with investors shifting out of risky assets into safe Treasuries (see Graph below)
So are these firesales indicating the presence of buying opportunities? Mark Kiesel from PIMCO is cautious. “Now, with credit spreads at all-time wides, we are more positive on credit valuations, simply from the standpoint that investors are finally getting paid now to take selective credit risk. Nevertheless, the real effects of the credit crunch will be felt throughout the overall economy over the next year, and near-term deleveraging is likely to continue with near-term negative market technicals with more risky bond sellers than buyers.”