No. of Recommendations: 8
Bond spreads indicate the risk premium that bond investors earn to take on the risks inherent in lending money -- default, inflation and rising interest rates.

The wider the spread, the greater the reward (or risk protection). The narrower the spread, the lower the reward (or risk to the lender).

Narrow spreads correlate with low financial stress. As lenders sense growing risk, they demand higher interest rates to lend. Financial stress rises with higher interest rates. The ultimate financial stress is a liquidity crisis, as in 2008-9, when the entire market froze up, financial stress skyrocketed and interest rates soared. Smaller rises in financial stress can be seen during the Euro sovereign/ bank almost-default crisis in 2010, 2011 and 2012. (These also correlate with drops in the stock market.)

Today, financial stress is super-low. The level matches February 2007, just before the recession began. (This is when unemployment rates began to rise.)

http://research.stlouisfed.org/fred2/series/STLFSI

The BofA Merrill Lynch US Corporate Master Option-Adjusted Spread is slightly above the 2007 level. The Federal Reserve tracks many bond characteristics. The Option-Adjusted Spread of BBB and =< CCC corporates are also slightly above the 2007 level but they are historically low.

http://research.stlouisfed.org/fred2/series/BAMLC0A0CM

http://research.stlouisfed.org/fred2/series/BAMLC0A4CBBB
http://research.stlouisfed.org/fred2/series/BAMLH0A3HYC

The Federal Reserve is keeping yields low by pumping massive amounts of money into banks. The Fed buys assets from the banks (e.g. mortgage-backed loans) with money that the Fed conjures out of thin air.

http://research.stlouisfed.org/fred2/series/RSBKCRNS

The Fed has already slightly tapered the rate of its purchases (not enough to matter), but it has announced an intent to keep interest rates low until 2015.

The heavy hand of the Fed has distorted the bond market dramatically. Since banks are paying practically no interest, many investors have bought lower-rated, riskier bonds in a stretch for yield.

Investing in bonds when spreads are at historic lows can be very risky. Bond values will plunge unless the economy stays slow and the Fed keeps pumping.

Wendy
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