Credit market gloom

Equity markets are cheering up. Why will credit not come along?

Perhaps the greatest cause for concern amid the equity rally is that credit markets, the target of all the rescue operations, are still working on the assumption of absolute disaster.

Deutsche Bank has published a study of how gloomy a reality the credit market is predicting. It takes the current spread between the yields on corporate bonds and similar government bonds and derives the default rate needed over the next five years for the corporate and government debt to end up paying out the same amount.

This varies depending on the recovery rate – the proportion of the principal on defaulted bonds that is recovered.

If recovery rates are at the historical average, the iBoxx investment grade corporate bond indices are priced for default rates of 38 per cent in Europe; 40 per cent in the US; and 51 per cent in the UK – all worse than in the Depression. If recovery rates are zero, the implied default rates range from 24 per cent to 31 per cent.

The worst five-year default rate since 1970, in all three jurisdictions, was 2.4 per cent.

Nothing has changed in the two weeks since Deutsche ran the numbers, even as equities have rallied. Bonds rated BAA by Moody’s now trade at a spread of 6.78 percentage points over Treasury bonds, near last year’s high of 7.2 percentage points. In February this spread was much tighter at 6.14 percentage points.

What do we learn from this? First, equities and credit cannot both be right, so those who like equities should pile into credit.

Second, there are only two explanations for the divergence. Either the credit market is so illiquid that these numbers bear no relation to the outcomes that investors expect; or we are in for a re-run of the Depression. The success of the rescue plan, the rally in equities, and much else besides, is predicated on the first explanation being correct."