Throughout the credit crisis, equity markets have proven to be steps behind their debt counterparts. Could it be happening again?
Credit spreads are sending up fresh smoke signals. The iTraxx Crossover index of mostly junk-rated companies hit a record high of 614 basis points this week. It cost as much as €615,000 (Rs3.6 crore) to insure €10 million of bonds against default for five years, triple the rate from the beginning of the crunch last summer. The 10-year index was at 609 at the same time. The five-year index grew wider than the 10-year index for only the second time, a potentially bad sign for the short-term outlook.
It’s not just high-yield borrowers either. This week it cost more than ever to insure against the default of investment-grade companies, as tracked by the iTraxx Europe index, which includes Credit Suisse Group and Tesco Plc. The spread there reached 126 basis points, up from 56 at the start of the year. BNP Paribas SA reckons the index is pricing in a default rate five times higher than has occurred in 50 years.
Traders partly blame technical factors for the spike. The market fears it is about to be hit by a flood of undesirable structured credit products as positions are unwound. That pushes spreads wider as investors use credit derivative indices to hedge against the exposure. But the lack of sellers of protection at these distressed prices also reflects genuine credit worries. Indeed, today’s investment-grade credit risk spreads are comparable with previous recessions, according to strategists’ models.
This extreme bearishness hasn’t permeated today’s equity markets, however. The FTSE Eurofirst 300 index is up 3.7% over the past month. Equities and short-term credit protection usually correlate. The last time they fell out of step in July 2007, it took a short while for equities to catch up with the credit market’s well-founded fears. Equity fund managers have since acknowledged they weren’t on top of the credit markets back then. It’s not clear they’re paying attention now either.