April 17, 2009

Bond vs Equity 

We are at economic inflection point; when business as usual returns and what is usual is being figured out as we go. How quickly the world economy returns to normal—and indeed, what “normal” is going to be—will depend on hard-to-predict factors such as the fluctuations of consumer and business confidence, the actions of governments, and the volatility of global capital markets.

Credit normalization is the key to equity performance over the next little while. Without access to financing equity prices will remain under pressure. If you believe that bond professionals are better than equity analysts, which I do, then yield behavior of credit instruments should provide some clues. In addition, cost of debt is an important metric for equity valuation, the higher the cost of capital the lower equity value should be. 

The bond and equity markets have diverged over the last few months. One was priced for hooverville and the other for normal recession. Then, the reverse occurred, equities woke up to the realities of the economy while the bond markets recovered some bit. Now with the market rallying some 25% since its lows, the question is does the bond market agree with equities?  

Well the answer this time is somewhat difficult than in the past. Debt markets have been mostly flat during the recent equity rally. Actually you can argue that the treasury yield rise is positive for equity, as investors shift money from non yielding assets to equities. Another point is the elevated spreads on corporate and other instruments are now pricing risks appropriately, as historical low spreads leading to the credit crises were an aberration.

The credit environment is much better than last November on all fronts:  
  • Corporate spreads have seen improvement since Dec 08 but did not participate in the recent equity rally and stayed mute for the most time.
  • High Yield spreads remain high as evidence of defaults and low recoveries are starting to appear in bankrupt company data. However the market is far better for Q4 2008 and deal are being done even for the riskiest companies, see here
  • Sovereign debt is stable and bodes well for Emerging Markets. Actually sovereign debt has been on a tear since Dec 2008.
  • Commercial mortgages spreads remain elevated except for AAA rated paper.  
  • Bank loan markets improved since last Dec 2008. Deals are being done, see here.

The consensus right now is we are going to have to revisit the lows and equity to head down. However, credit has improved so much form November of last year. Although I do not see any sustainable rally we may just languish in range bound market. Yet again who knows?? 

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