Who is Right – Bond Market or Equity Market?

If there really are signs of financial recovery, nobody told the bond market. Treasury Secretary Timothy Geithner’s plan to rescue the financial system sent the S&P 500 soaring 7% on Monday alone, bringing its gains from March 6 to an impressive 19% through Wednesday. But credit markets have hardly budged.

[Spread Alert]

Corporate debt is still priced for disaster. Investment-grade nonfinancial U.S. corporate bonds rallied in January but now have stalled, with spreads about four percentage points over Treasurys, based on Markit iBoxx indexes. More worryingly, even as bank stocks have climbed, with the KBW index gaining 54% from its lows, U.S. senior bank-bond spreads remain at their widest levels since Lehman Brothers collapsed.

Looking at the performance of the underlying assets the banks hold, there has been some improvement in commercial-mortgage-backed securities, with the triple-A portion of the CMBX index rallying sharply in the past week, albeit remaining extremely wide at 5.99 percentage points. But leveraged loans as measured by the LCDX index remain unloved, with the index, at 74% of face value, still close to its all-time lows. Meanwhile, corporate defaults are surging: S&P by March 20 had recorded 47 defaults globally so far on the year, nearly triple the number seen in the same period of 2008.

Bonds are pricing in unheard-of and devastating levels of default. Deutsche Bank recently calculated dollar investment-grade corporate bonds were pricing in a five-year default rate of 40% assuming average recovery rates. Even if one makes the unlikely assumption that bondholders recover nothing after default, prices suggest a 25% default rate over five years. The worst five-year investment-grade default rate since 1970 is just 2.4%. The average is 0.9%.

On that basis corporate debt is almost absurdly cheap — and so a lot of investors are pumping money into the market. That this has failed to fuel a rally in the credit markets similar to that in equities should ring warning bells for stock-market investors. What is holding back the credit markets is a lack of demand for financial debt — a sure sign that all still isn’t well in the banking system.

Demand in the credit markets is mostly for nonfinancial debt, but this is being met by huge supply as borrowers look to bypass the banking system, thereby preventing spreads from tightening. The vast majority of financial debt finding buyers is that guaranteed by governments — hardly a vote of confidence. Asset-backed securities and leveraged loans remain unloved.

Until investors recover confidence in financial assets, credit spreads are unlikely to tighten significantly. And without a sustained improvement in the credit market — the seat of the crisis — it seems irrational to expect a durable move higher in equities.

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