Don’t trust bond spreads

Spread between 10Y US AAA Corporates and 10Y US Treasuries, 1962 to 2012

The chart above shows the difference in yields between AAA 10Y US Corporate bonds and 10Y US Treasuries. This difference, known as the spread, reflect the relative riskiness of the two assets. As risk increases yield must also increase to compensate investors. And as the spreads widen conventional wisdom tells us risks are higher.

Curiously, there have been several periods of time in history when US Corporate bonds were perceived by investors as less risky than treasury securities. In spite of all the well known US economic problems we see Corporate bonds are yielding much, more than treasuries. I don’t believe this is an accurate reflection of the situation. Unlike the US government, American corporations are sitting on record amounts of cash. Unlike the US government, American corporations have cleaned up their balance sheets, lowering their overall debt levels significantly. So why are the spreads so high?

Unlike Corporations, the US Government can effect a large degree of control on yields. The Fed has said they fully intend to maintain low interest rates until 2014. So the traditional tools and techniques aren’t as effective as they used to be. In other words, when Central Banks mess about in the markets, you’ve got to be very, very careful about how the data is interperted.

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