Default Insurance Costs at New Low

I mentioned earlier that investors in Toll Brothers' (TOL) bonds were not paying up for insurance against a possible default. This is evident in the credit default swaps (CDS) for Toll's bonds. In a credit default swap, there are protection buyers and sellers.

The buyer pays a price, specified in basis points, for protection against default. Most CDS are for a term of five years.

Dow Jones has an index that helps us to gauge the amount of protection being bought on 125 investment-grade entities. Tracking the index helps provide a sense of risk attitudes in the market.

Recent behavior of the Dow Jones credit default index indicates that investors are not all that worried about default risks, and hence are optimistic about the outlook for future cash flows, the main driver behind corporate profit and a company's ability to repay its debts. The index also could be viewed as a contrary indicator reflecting high levels of optimism.

Yesterday, the Dow Jones credit default index traded at 33 basis points, meaning that investors were paying 33 basis points on average for protection against defaults that might occur on bonds issued by the 125 entities in the index. That is the lowest since the data series began in March 2005. The 2006 high was 46 basis points in January and June, and it traded as high as 78 basis points in May 2005.

Is this a sign of confidence or complacency?

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Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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