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Subject:  Re: bond spreads - corporate debt risk premium Date:  10/27/2001  1:02 PM
Author:  remedialstudent Number:  96 of 297

The wide and widening spread between treasury and corporate debt yields is something that has interested me ever since LTCM blew up in 1998. As nearly as I can tell, the focus on LTCM's problems (aside from the massive leverage they employed) has been almost entirely on the risk side of the equation. The problems on the risk side have been well documented, but there's been little to no focus on what's been happening on the risk-free side, i.e. the treasury yields which LTCM funded with.

The risk side is easiest. Moody's used to document it weekly (I really miss getting Lonski's reports free from Moody's website). Credit downgrades have outnumbered upgrades dramatically since early '99. My first instinct when I heard this was "So What?", you downgrade the bonds and they go from Aa to Aaa, how does this push the yields of Aa's overall up? But then I figured that the ratings agencies lagged the market -- the market was steadily pushing the yields of these bonds higher (relative to other yields) while Moody's was still calling them Aa.

However when you get the downgrade, this should push both Aa's and Aaa's lower since presumably a bond recently graded Aa should still be a mrginally better credit than one that has been Aaa for years, and Aa would improve from the benefit of no longer having bonds near downgrades included in their ranks. I think this explains some of the increased volatility and the seeming cyclicality in the spread between lower and higher graded corporate debt over the last few years. Yardeni has a more in-depth look at quality spreads that has this info

But in any case, While historically, Moody's Aaa's are trading at their highest spread to treasuries and Baa's are trading at their highest spreads to treasuries, corporate/corporate spreads have not come close to their 1990 recession highs, or their mid-80's levels. This is consistent with the idea that bonds have been consistently graded down and have tended to make lower ratings appear relatively more secure than previous indexes and higher grades relatively less secure.

But, it does not answer why all grades have increased in yields relative to treasuries though, and we know balance sheets have been in worse shape before. It also doesn't explain why commercial paper yields are at historic lows relative to T-bills. Corporations are a great bet for the next 3 months, but not the next 10-20 years? Maybe, but that's not the way its worked in past recessions. And it doesn't jibe with corporate equity action where all stocks were graded up relative to treasuries (and still are) and blue chip companies were graded up relative to less secure ones. There might be some answers to this inconsistency, but I haven't found them. I'd be glad to hear ideas