CDS Flinch As Corporate Bonds Play Chicken With Equities

Several days ago, we talked about the Federal Reserve’s intent of improving financial conditions by way of balance sheet expansion and QE. Their recent policy action is generally supportive of risky assets such as corporate bonds and equities. Since the announcement, spreads and equities have performed as expected.

Interestingly, not everything is right in the marketplace. With the re-emergence (again) of the European debt crisis with Spanish government bonds reaching 6%, the recent rally in equities has started to unwind. Conversely, the tightening in the spread for Investment Grade Corporates has not and has remained near tight levels.

Since the market closed at 1465.77 which is the most recent highest close set on September 14, 2012, the S&P 500 has fallen more than 24 points as Tuesday. This modest decline of 1.7% has led some to wonder if this is the end of the rally. During that time, the spread or additional yield over U.S. Treasuries of the Barclays’ U.S. Credit Index--which is a proxy for high grade corporate bonds--has remained the same, at 144 basis points.

Big picture market thinkers know the interconnection between the corporate bond market and equities. Wider spreads lead to falling equity prices and vice-versa. Here, that relationship appears to have broken down for the time being with the culprit being the Federal Reserve.

Given the supply trends of the various fixed income products, the Fed’s planned purchases of MBS will undoubtedly overwhelm the amount of new issuance for most taxable bonds. This activity could lead the net supply of the aforementioned sectors to be close to zero or perhaps even negative. This reality could create a scarcity problem for bond investors. Those that realize this (which appears to be everybody) could be reluctant to sell which explains the lack of movement in the spread of the benchmark.

While corporate bonds have maintained their gains, other credit products that are less constrained by dwindling supply, have not. In particular, the spread of credit default swaps (CDS) which are derivatives that mirror the same credit risks of corporate bonds, have widened.

The spread on the benchmark index, CDX Investment Grade (IG) 5-Year has widened by almost 20 basis points to a spread of 102. This spread, which is usually correlated to corporate bonds, is widening due to either selling of credit risk or an increased interest to sell short.

In the chart below, the green line represents the spread on the CDX IG 5-Year and is on an inverted scale so that if spreads widen, they will move in the same direction of falling equity prices. The spread on the Barclays U.S. Credit Index and the S&P 500 Index price are represented by the white and orange lines, respectively.

CDS is a swap designed to transfer credit risk and is originated between two counterparties. As a result, CDS origination is not limited by the amount issued by the corporation but more so limited by finding a counterparty to take on an offsetting view. Unlike the corporate bond market where shorting occurs less often, this dynamic allows an investor to freely take on a view on either the bull or bearish side of the creditworthiness of a company. This freedom is why spreads are widening in the CDS market which contrasts with the lack of movement in corporate bond spreads.

Having said this, warning signals are filling the sky emanating from the market’s take on the creditworthiness of corporations. Historically, this is revealed via jumps in spreads of the transparent corporate bond market. Without knowing the overwhelming effect of QE on the markets, the lack of movement in corporate bond spreads would suggest that all is fine. However, the sudden gap in the CDS market suggests that the selloff in equities may have some legs to it.

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