By JUSTIN LAHART New research shows corporate bonds have been far better at predicting where the economy is headed than anyone thought. Unfortunately, that suggests the economy is going to get much worse. In the fall of 2007, before the economy began to falter, corporate-bond prices were signaling all was not well. The spread between corporate-bond yields and Treasury yields, which had begun to widen amid that summer's mortgage woes, showed little improvement even as the Dow Jones Industrial Average clocked record highs. It wasn't the first time bonds had signaled something was awry. One of the head scratchers of early 2000 was why stocks were surging when high-yield bonds were wavering. In retrospect, the bonds had it right. Bond investors are intensely focused on companies' ability to pay down debt. If they see signs business is slowing, they demand higher returns, and thus higher bond yields. Widening corporate-bond spreads can also reflect disruptions in the credit supply -- say, because banks are mired in bad mortgages -- that eventually sap the whole economy. Finally, widening spreads can induce companies to cut back on expansion plans, which also has economic consequences. Bonds' forecasts haven't always seemed to come true. Many corporate-bond indexes showed spreads widening significantly during the 1998 Russian debt crisis, and yet the economy soldiered on. Such false signals mightn't be because of corporate bonds themselves, however, but the way corporate-bond indexes are constructed. The bonds in them tend to have much shorter times before they will mature than the 10-year Treasurys that their yields are usually compared with -- which makes for a faulty comparison. To compensate for that, economists Simon Gilchrist and Vladimir Yankov at Boston University, and Egon Zakrajsek at the Federal Reserve constructed credit spreads over the 1990-2008 period from monthly price data on the corporate debt of about 900 U.S. nonfinancial companies. They divvied up the bonds based on both expected default rates (a more timely measure of quality than ratings) and time to maturity. In a forthcoming paper in the Journal of Monetary Economics they show that spreads on low- to medium-risk corporate bonds, particularly those with 15 or more years until maturity, predicted changes in the economy phenomenally well, forecasting the ups and downs in both hiring and production a year before they occurred. Since writing the paper, they extended their analysis back to 1973 and found bonds' predictive ability still held. It would be better for everyone if it doesn't hold in the future. With the massive widening in corporate-bond spreads last fall, the economists' model predicts industrial production will fall another 17% by the end of the year, and the economy will lose another 7.8 million jobs on top of the 5.1 million it has shed since the recession began. Ouch.
Nice find. Link to article: http://online.wsj.com/article/SB123929216724105401.html Interesting way to go about separating the variables out. I think they're pretty right on for the short-term. Should be interesting to see how future inflation will affect their models. -troll
Junk bonds have been on a tear since the Fed meeting in early March and some junk bond funds haven't so much as had one down day, they have been either up or unchanged. Since their mid-December lows, junk bonds are in the midst of one of their largest, if not largest, four month rallies ever with a significant narrowing in spreads. Just yesterday, Moody's lowered their predictions of the peak default rate for the third time in the past two months because of all the added liquidity in the system. At their mid December lows junk bonds were pricing in something worse than seen in the the 1930s. In other words, unless you believed that to be true at that time, they were the buy of a lifetime. When stocks went down to new lows in early March, junk bonds did not revisit their lows, much like what in occurred in March of 2003, and indicative that stocks were a buy. Note, I am talking in this thread about the cash junk bond market and the open end junk bond funds. The closed end junk bond funds as well as the three ETF junk bond funds are not indicative on a day to day basis of what is occurring in the cash junk bond market because of their propensity to go to discounts and premiums to their NAV.
An interesting article, and it would be great to read the original paper... One thing to keep in mind is that never during the authors' sampling period had the market experienced the type of stimulus that is being applied to the system now, which would suggest taking their findings with a pinch of salt indeed...