What bonds tell us about stocks
Jul 12, 2006
Amid the recent market uproar, one asset class has remained surprisingly resilient. High-yield (ie, more risky) bonds have moved relatively little: their credit spreads – the difference between the yields on the riskier bonds and on safer US Treasuries – have risen by only around 40 basis points since early May and remain low by historic standards. (Bond prices move inversely to yields, so this means that prices have fallen relatively little compared to the prices of Treasuries.)
This is unusual. As the FT’s Lex column notes, “significant declines in equities and widening high-yield credit spreads have gone hand-in-hand over the past decade”. So the fact that bonds have moved so little seems at first to support the idea that the recent falls in equities will be just a blip.
But maybe not, says Lex. One reason that equities have suffered more than bonds is not because of inflation, but because of fears that the Federal Reserve will overreact to inflation and raise interest rates too hard, hurting US growth. US growth rates are seen as a good guide to future bond default rates. In turn, the expected rate of default drives up high-yield credit spreads (as lenders want high yields for higher risk). So slower growth may mean more expensive credit – which is not good news for equities.
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