《【妖舞魔亂】Credit Markets and Yield Spreads - What It All Means》

 

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POSTED: Friday, October 03, 2008
http://www.reuters.com/article/blogBurst/

For those who don’t deal with this stuff regularly, here’s a great brief primer on credit markets, various types of borrowing, and what “spreads” are and why they are so important to understanding what’s currently going on in the credit market, in the form of a Q & A with Manish Jain, the Fixed Income Portfolio Manager for Zacks Investment Management:

What exactly happened when “the markets froze” that caused the fear of a market meltdown and the need for a $700 billion bailout by the Fed?

Basically what’s going on is a crisis of confidence. It’s a lack of confidence at the person sitting across from you when you are lending him money. What AIG, Lehman, Bear Stearns and Merrill Lynch have taught us is that how quickly a company can be collapsed.

With this fear in their mind, banks have been reluctant to lend money and have been hoarding cash in case they themselves need it for their own survival. Rates on any unsecured lending have again shot up dramatically over the past week…

What about Commercial Paper? Did this trading stop for some time period?

The Commercial Paper market involves companies borrowing money either overnight or for some really short term (7 days or 30 day). In some cases they can go up to one year. The borrowings are mostly unsecured. A lot of companies borrow money in this market for their day-to-day operations. The types of companies borrowing span the entire globe, but mostly its financial companies.

The Commercial Paper market has not stopped but has shrunken quite a bit over the past couple of months. As lenders demand higher and higher rates, borrowing companies are either forced to pay up the higher rate or issuer longer term debt so they don’t have to go back to the market on a daily basis. In either case, the borrower is forced to pay a lot higher rate than what they were paying before…

Can you tell us a little about LIBOR?

LIBOR means London Inter Bank Offering Rate. It is calculated and issued by the British Bankers Association (BBA). It is the rate that the banks lend to each other for various maturities. There is the overnight Libor rate, 1 week Libor, 3 month Libor, 1 year Libor, etc.

I believe there are about 16 banks that participate in this, and each one of them submits early in the morning the rates where they can borrow money from other banks. BBA lops off the lowest as well as the highest rate and then calculates the average from the remaining rates. This rate is then published around 11:00am London time and is used as a reference rate for borrowing purposes world-wide. A lot of floating rate loans are based of Libor rates. These include variable rate borrowings by corporations, adjustable rate mortgages, home equity loans, etc.

How does Libor impact you? If the banks are going to be charging a higher rate to lend to each other because they don’t trust the other bank’s strength, then the rate that we are paying on our loans will go up. For another example, the 3-month LIBOR rate on Sep 1 was 2.81% and it was at 3.76% [late last week]. For someone whose loan rates are based on the 3 month LIBOR rate, they basically saw their borrowing cost increase by nearly 1% over the past month. So as credit becomes tight, our borrowing rates have increased along with it.

Thanks. Can you clear up what “spreads” are for us?

When people talk about spreads, they are talking about the difference between the yield of a corporate or municipal bond and the yield earned on a U.S. Treasury bond for the same maturity. The lower the spread, the more people feel comfortable with the company’s likelihood of paying off the debt. If the spread is high, that means people are concerned.

The U.S. Treasury rate is your risk-free rate. There is very little chance of Treasuries defaulting. Investors use that as a starting point and then add premium to the rates depending on the chance of a company going bankrupt.

By way of example, up until now General Electric usually has been able to issue bonds at a spread + 50 bps [basis points] to the Treasuries. So if the 5-year U.S. Treasury is yielding around 3%, then GE is able to sell their bonds at a yield of around 3.5%. On the other hand if you are looking at General Motors, then the spread may be +400 bps to the Treasuries.

As investors feel uncomfortable about a company, the yield spreads on their bonds start to rise. So right now financial companies yield spreads are shooting up.

I was offered a bond issued by Citigroup that will mature in 5 months and it is yielding around 6.3%. For comparisons sake, 6-month Treasuries are yielding around 1.5%. So the spread is around 480 bps. That is junk bond territory. It does not have to be Citigroup — you can take a look at Bank of America, Merrill Lynch, Morgan Stanley, etc. The yield spread on all of the financial company bonds have gone up. Consequently, if these companies want to borrow money, they have to pay obscenely high rates.

How about mortgage-backed securities?

Most of the MBS paper that I have dealt with has been issued by Fannie Mae or Freddie Mac.  Since the U.S. Government took over the agencies, their debt has been trading very well. There are going to be some mortgage defaults within the bond, but with the U.S. Government basically guaranteeing the principal and interest payments, investors have felt a lot more comfortable with the product. Remember, there are still actual homes/mortgages backing the bonds and a majority of them are still paying on time.

I can save you time and tell you about some of the other components. The Leveraged Buyout Bond Market is basically shut down right now. No one is willing to buy debt of companies that were bought out by private equity companies.

The Credit Default Swap (CDS) market has also slowed down quite a bit as investors don’t know if the company on the other side of the trade is going to be around or not.

In the past few weeks, spreads, starting with LIBOR, the rate banks charge each other, have increased dramatically.  The global money lending system is slowly shutting down.  At the same time, a lot of people and institutions have dumped their other investments and “stashed” their funds in US Treasuries.  The result is that prices have increased and Treasury yields have decreased, widening the yield spreads even further.

Just to make the point a bit more starkly, we have this from Bespoke Investments on the spread on High Yield Corporate Bonds:

After surging more than 150 basis points in the last week, the spread between high yield bonds and comparable treasuries has surged to 1,096 basis points based on the Merrill Lynch Index of High Yield Bonds.  Additionally, at current levels the spread is only 2% off its record high from October 2002.  In other words, with the 10-Year US Treasury currently yielding about 3.75%, companies with ‘junk’ rated credit currently have to pay just under 15% to borrow money.

 

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