Are Credit Markets Back to Normal?

The credit markets have markedly improved since the March bottom of the S&P 500. This development is significant because it is likely to boost banks' profits, helping them to exceed analyst expectations in the coming quarters and to raise capital independently. That in turn will enable the Treasury department to start withdrawing its TARP money from the banking industry.

There are several signs of this improvement:

One, secondary market liquidity has improved. The TALF program triggered an increase in debt issuances and caused their spreads to tighten.

Second, TED spread has compressed (see chart below). TED spread is the price difference between 3-month T bills and 3-month Eurodollars. It is a historical indicator of credit risk: as default risk is decreasing, the TED spread declines because T bills are considered risk free while the Eurodollar reflects the credit ratings of corporate borrowers. Note that from a peak of 4.6%, the spread is now down to a typical, pre-panic level of 0.6%. This is a positive sign that credit markets are functioning normally again.

Third, high yield bonds are rallying, as shown in the chart of high yield bonds below, another sign of liquidity and confidence returning:

Another noteworthy point: the S&P 500 five year average earnings yield is now about 4 percentage points higher than the yield of ten year government bonds.

The difference between the earnings yield and the bonds yield has historically been a good benchmark for value, because of the constant trade off between them (if you can get a better return by owning guaranteed government bonds, you wouldn't buy stocks, which are not guaranteed but do grow their earnings over time). That difference was the largest (7%) at the market's bottom in March (meaning S&P 500 stocks were cheapest compared to bonds), and it is now still much larger than other major bottoms, including the generational bottom of October 1974.

Credit markets may not be completely healed, but they are in much better shape than they were three months ago.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at [e-mail].

Comments

[yappnmutt]

this situation provides an excellent trading opportunity and will enhance banks net income but it does little for the economic situation. the yield on t bills are going up, in part, because of the sheer amount of debt being sold by .gov. the commercial yields are rising because of the need for financing in a constricted market. the yield on earnings will be adjusted downward. the future yield is in doubt.

the bursting of the bond bubble is not a good thing.

[research]

You hedge fund guys never give up. Credit Default Swap insurance is still being issued without reserve.

the next hiccup, will activate those claims and we will have another AIG bailout for TARP fund to pay.

Investment insurance is fraud.

[DiogenesOfAlaska]

Well, if credit default swaps are monitored closely and settled in a timely fashion and backed up with enough collateral ... they are not fraud at all.

Which is not, of course, what AIG did. Hence I agree and disagree. Because I think you are right and wrong.

It's like any other insurance: if you sell it without the capital to cover losses, then it's indeed fraud. This is precisely why there is no way regulatory arbitrage (regulator 'shopping') can be allowed to continue. Transactions must be viewed for what they are, not for what's written on the back of the envelope. And that immediately implies that complexity must be cut down. Because otherwise it's impossible to do the monitoring. To say that this is 'killing innovation' is a digression. Innovation must be tested and testable, otherwise it really IS a WMD. And for lobbyists to even debate this point is enough to take away all credibility from them. This is obvious.

[research]

I agree that closely regulated and monitored investment insurance probably wouldn't have exploded in our faces.

But the very concept of investment insurance is absurd.

The only way to insure investment is to diversify.

CDS were deliberately deregulated by a conspiracy of JPMorgan and Phil Gram and GOP.

I have a bunch of interesting links on my profile.

CDS are off track betting with borrowed money.

[Rule Of Law]

If this is true, then why are so many small businesses in America still having great difficulty getting loans for their critical working capital? The short term money that is the lifeblood of 95% of business in this country.

[DiogenesOfAlaska]

These indicators are of very little consequence with respect to lending to small businesses. But at least there's some relaxation visible.

[Rule Of Law]

I'd like to hope that you're right, but for a lot of us small business owners, it's tough to find any relaxation at all.

[DiogenesOfAlaska]

Agreed with your conclusion that credit markets are in better shape than months ago.

But I have a question about your interpretation of the TED spread: while the sharp drop is clearly comforting, there's still the possibility that T-bills aren't an appropriate benchmark for risk-free rates anymore.

I'm not worried, I'm just saying. The other indicators remain untouched and the drop in the TED spread is indeed sharp. I didn't look at the orders of magnitude with more precision, it just came to my mind.