Not that long ago we had the soothing words of “containment” and “no spill-over” thrown at us daily, keeping the financial masses calm as the turmoil in the sub-prime derivative markets grew. We know how false those words were as we look around today and survey the damage across the whole credit system. 

Yet when we gaze at the stock markets we see constant recoveries from lows. Over the past few weeks ranges have appeared on the main indices that have contained even volatile up and down moves. The markets appear to be waiting for the next development but still respect certain parameters:

Dow Daily, click chart for larger image:

As you can see the Dow isn’t out of control, far from it as the chart shows. The chart displays a propriety indicator that has an extremely good track record in all market conditions. No random walk here. The light blue horizontal lines show the support and resistance of the current sideways range. (support could be considered at 12200 too, if you wish). We have heard just about every explanation of why the range has formed, be it Federal Reserve speeches, release of economic data or company results. None of these reasons satisfy my questions. This doesn’t mean news isn’t important in the short term but overall I see little effect. So what are the stock markets waiting for?

I think I may know.

I have been watching for a spill-over effects from the credit crash in the Corporate Bond markets. Just like any credit market the first signs of risk aversion occur with the lowest rated bonds. Remember, bonds are better quality than shares especially in a default or bankruptcy of a company. You have more chance of recovering capital with bonds compared to shares, even lower rated bonds.

Bond markets dwarf stock markets, they much greater liquidity and bonds can be traded just like shares between Institutions. Did you know that bonds can also be traded on stock markets? Thanks to the introduction of ETF’s anyone can trade bonds. It also means anyone can adopt strategies that allow for hedging of bond holdings or move risk between stocks and bonds in the same company.

Enough of the freebie advert for ETF’s, here is why my attention has been drawn to corporate bonds, click on chart for larger image :

In order, from top line to bottom line on the chart: Moodys Seasoned Baa Corporate Bond yields, Moodys Seasoned Aaa Corporate Bond yield, Effective Fed Fund Rates and 3 Month Treasury Bill Secondary Market Rate. Did you expect to see yields on all 4 instruments lower? After all isn’t the reason the Fed is dropping rates to match the 3 month T-Bill an attempt to lower debt servicing levels?

Corporate bonds act a bit differently, notice how the Aaa rated debt has remained within the 5-6% range even as Fed funds rose from 2%, stabilised at 5.25% and fell back to 3%. For awhile Aaa was considered so risk free that it only had a minimal discount to the 3 Month T-Bill.

Not now. The discount to the 3 Month T-Bill has widened to 350bp and yet the price of corporate debt has remained stable. The market is saying that high rated company’s are okay, the credit crisis is not going to affect them. The slight downtrend from mid-’07 would show that Aaa has even attracted buying. Yet as we know shares have faired badly since mid-’07. Surely the fundamentals for shares and bonds are the same, except for default risk?

Maybe it’s the default risk that we need to look at more closely and that brings us to the Baa corporate debt. It probably caught your eye too, since mid-’07 Baa yield moved higher and seems to be in an uptrend, diverging from Aaa debt.

I like divergences, they always point to something interesting. In this case it looks as though the risk premium for holding Baa debt over 3 Month T-Bills has become an imperative for buyers. The discount has widened from about 110bp in early ’07 out to nearly 500bp a year later. That’s some move.
Corporate debt buyers are sending a message, holding Aaa rated debt has become riskier, not because of company fundamentals but because of a credit crisis.

Baa debt on the other hand is pricing in a risk to a fundamental change in company outlook and that risk has accelerated since the beginning of 2008.
Is the Corporate Bond market attempting price in “containment” of the credit crisis? The attempt to discount the risk of spill-over may come back to haunt them.

My advice would be to sort through your share and bond portfolio and check out the ratings on each company’s corporate debt. Do some research on corporate bond ETF’s and see if there is a strategy that might suit your circumstances. I suspect the Financial Institutions might well have been doing the same over the past few weeks.

Market Snippets

It would appear that a deal to bailout Ambac, the struggling bond insurer, is close although not yet final. The deal consists of a split of Ambac assets, with a top rated municipal bond business being formed and a separate structured finance vehicle used for the risky assets. The deal could be announced Wednesday (5th ) or possibly next week to avoid stock market turbulence, according to an anonymous source close to the talks.

Federal Reserve officials are voicing renewed concern about the fragile state of U.S. financial markets, along with worries that more sectors may encounter new waves of turmoil.

Commentary by Mick Phoenix

on behalf of An occasional letter from The Collection Agency

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. The views in the article are for informational purpose only.