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Corporate bond valuation update

This chart shows spreads on 5-yr credit default swaps, for investment grade and high yield corporate bonds. Spreads have surged since July, and are now back to levels that preceded and foreshadowed the onset of the worst of the Great Recession. Is this a sure sign that we are on the cusp of another recession? As much as I think spreads are excellent and forward-looking indicators of economic and financial market fundamentals, I don't think this chart shows the whole story.

This second chart compares 2-yr swap spreads to junk bond yields. Swap spreads are excellent and forward-looking indicators of systemic risk; today they are in the upper range of the levels (15-35 bps) that typically prevail when the economy is navigating relatively stable seas. Swaps did an excellent job of predicting the collapse of the junk bond market in 2008, and an excellent job of leading the huge rally that began in late 2008 and continued through last year. Today, swap spreads are signaling only mild upper pressure on junk yields—nothing to get very excited about.

So why are spreads on corporate debt (top chart) so high? It's mainly because the yields on Treasury debt are extraordinarily, incredibly low. The European sovereign debt crisis has created gigantic demand for Treasury debt, greatly depressing yields in the process. The big widening of corporate debt spreads is only partly due to a deterioration in the prospects for U.S. companies, and mostly due to the desperation that is gripping European investors.

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