All Stressed Out From What?

"You can observe a lot just by watching."
-- Yogi Berra

Baseball literature is silent on Yogi's talents as a bond trader, but we can assume the observant backstop would have noticed all the talk about how tight credit spreads have been during the past three years.

Just as the narrow VIX was alleged to be a sign that we collectively were cruising for a bruising, tight credit spreads were cited as prima facie evidence that corporate credit was priced incorrectly. Hellfire and damnation were sure to follow.

Of course, the alarmists have to address the issue of why we have been chugging along for more than two years with spreads for both high-yield and investment-grade bond spreads near current levels. In essence, credit spreads have not changed since it became apparent the Federal Reserve would have to start raising the federal funds rate.

The Bend at the End

Just as paranoid people have real enemies, alarmists occasionally are in tune with the market. Credit spreads have risen unmistakably since late February, the very time the yield curve came out of an inversion. Are these two events linked, or are there other factors behind rising financial stress?

Click here for larger image.

Source: Bloomberg

Let's return to the relationship between Standard & Poor's economic sectors, which I wrote about in May 2005, and combine it with constructed indices of credit default swap (CDS) rates, which I touched on in the same article, and the family of primal market factors, which I wrote about in February 2005.

The idea here is simple, even if the execution is not. The depth and liquidity of the CDS market, last discussed here in the context of Dana's bonds in March, has risen to the point where active corporate bond traders do not need to sell the bonds: They buy the CDS instead. As a result, the apparent yield spread between corporates and Treasuries remains static while the risk is transferred to the CDS market.

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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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