| Credit Spreads As Economic Indicator |
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| Written by Nick Osinski | |
| Friday, 23 May 2008 01:22 | |
 Remember the yield curve? Well, to freshen your memory, the yield curve is just the graphical depiction of the relationship between yields (required rates of return) and maturities. So, for example, the curve would tell you the kind of return demanded for their investment dollars when committed for a specific period of time (to maturity) - all else equal. While it might sound like a boring subject, it"s actually quite interesting in what it can foretell about expectations for our economy. Before we get to the credit spreads, you have to also remember that there"s not just one yield curve, but many - one for each level of risk determined by investors (and generally based on the ratings issued by the big ratings agencies). The credit spread, therefore, is the vertical distance between two curves - i.e., the difference between the required rate of return demanded by investors in securities of equal maturity, but different levels of risk. Why is this interesting? Well, this difference, referred to as the credit spread, is an indicator of what investor"s believe is the relative risk associated with lower-grade investments. Imagine, for example, that investors believe that we"re heading into, or are already in, a recession (I know, I know, how could anyone think that!). If you were such an investor, then you would likely believe that the lower-grade issuers of these securities were likely to see a slowing in their sales, cash flows and, ultimately, a weakening in their ability to satisfy their obligations to the investors in the securities they issued - yeah, that"s you and me. Well, to accept that added risk, you would demand a higher rate of return and this would begin to shift-up the yield curve for securities of similar risk. As that yield curve shifts-up, the spread between it and the safer (investment grade) securities grows. Ok, so now that you understand the mechanics at work, I"m sure that you can put one-and-one together and see how you can use the yield curve to evaluate what the economy is thinking. If you were to look at the yield curve today, however, you probably wouldn"t find what you were expecting. While most people would agree that we"re either in, or heading into, a recession, the yield curve doesn"t reflect it. With a spread of only 46 basis points, down for a high of almost four times that just a few months ago, we"re not seeing the affects of higher commodity costs, rising unemployment and record high foreclosures and bankruptcies. Does this mean that something in the mechanism is broken? Well, possibly, but there"s a silver lining to any dark cloud. Today"s yield curve tells us that the average investor hasn"t adjusted their expectations to what most others believe is our economic reality. As an investor, this information is golden. As an investor, you should always be looking for information about what will be, but hasn"t yet been accounted for by your fellow investors. Doesn"t this sound like what we"re seeing today? So, the question is, then, what will you do about it? How will you position your portfolio to take advantage of what appears to be an arbitrage opportunity?
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