Wednesday, November 2, 2011

Credit Spreads and Perceived Risk

The US fixed income markets trade in relation to the US Treasury market. If McDonald's has a 10 year bond, and McDonald's is perceived as riskier than the US Treasury 10 Year Note, then McDonald's will trade at the 10 year Treasury yield PLUS some extra yield spread. In trade lingo, one might hear someone say they have "McDonald's of 2021 at +100 to Tens" meaning they are offering McDonald's 10 year bonds at 100 basis points (1%) higher yield than the US Treasury 1o Year Note.

As the bond buying public perceives more risk in the US economy, spreads widen. In other words, that same McDonald's bond might trade at "+150 to Tens" when corporate profits and the US economy is suspect. Likewise, in a stronger economy with higher confidence, that bond may trade at +60 to Tens.

Over the last 12 months, corporate spreads on Industrial bonds in general have tightened. For example, on average a non-bank 10-year bond was trading at +103 a year ago and is now trading at +86. Consumer confidence is higher and the public's perception of risk is a bit lower. The one area that has widened over the last 12 months has been bank and finance paper. Some weeks ago when the future of Greece and perhaps all of Western Europe was in question, bank and finance paper widened out to +200 in the 10-year part of the curve. Over the last week, as the EU came to some agreement about how to help Greece, those spreads have tightened to +190, but bank and finance paper still has the highest yields available in the market.

As industries fall in and out of favor, and as corporations go through various events (HP deciding to stay in the computer business or Apple's death of Steve Jobs) Blue Haven Capital looks for opportunities to capture the incremental yield increases that such events generate.

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