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Two Markets



Brian watches closely the corporate bond market (I actually travel heavily in a subset of this market, convertible bonds) for indications of the interest rate spread widening or narrowing: lenders demand a premium interest rate when buying corporate bonds over government bonds because of the extra credit risk.

As the spread narrows, in general lenders are becoming more comfortable with the credit of corporations, and thus making it cheaper for companies to borrow. Brian alludes to a correlation between this and equity prices: as liquidity becomes available for companies to borrow, their borrowing costs (interest expense) are lowered and they can make higher profits. Additionally, the increase in liquidity that helped the bond market is bound to help the equity market as well.

I agree that this is a very valuable tool and should be watched for early indications of a turn in equities, but I also believe (and have stated before) that correlations between different markets depend very much on where in the cycle we are. When corporate spreads were very wide eighteen months ago because of an extremely high anxiety of default risk, equity prices were also reeling. This makes sense: if a company is going to default on a bond, its equity price is going to fall precipitously because bond holders have first claim on the assets of the company. As that anxiety abates and credit improves, there is likely to be a significant improvement in the stock price.

But in other parts of the cycle the correlation is not nearly as clear or significant. A company can be in an only moderately favorable environment or position, one that allows it to muddle along, stay solvent and be able to pay off its debt. In this environment its credit spread may continue to improve but its stock price may languish. Especially if the stock price is overvalued.

I agree that credit spreads are an important indicator of general economic health and that at various points they can greatly affect stock prices. But I also want to reiterate that the correlations between various markets are not linear: they change and can change dramatically depending on the environment.

No positions in stocks mentioned.

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