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Are Credit Markets Back to Normal?

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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.

2009-05-22-20090522TedSpread.gif

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

2009-05-22-20090522HighYieldBondIndexthumb.gif

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 aschram@wellcappartners.com.