Corporate / Government Bonds Yield Spread As An Astute Indicator For Equities
A Most Important Indicator
Corporate bonds has to offer higher yields than government bonds as the latter is deemed as the risk-free rate. The bigger the spread, the higher the cost of capital for companies. It is also a reflection on the returns demanded by corporate bond holders. If investors perceive a higher default risk, they will demand higher rates and yields on corporate bonds. The US bond market is deep enough as solid indicators, and study of the spreads will tell us a lot about whether the market is in a bullish or bearish phase.
The differentials since 2000 has been between 1.5% to a high of 4% (e.g. say US Treasuries is now yielding 4.8% and corporate bonds is yielding 6.5%, the spread would then be 1.7% - as a rule do not look at A/AA rated corporate bonds as they do not budge much, look at those corporate bonds rated BB/BBB). Generally 2.5% is a normal spread in a neutral market phase, as a general rule of thumb. The spread jumped from 2.5% in early 2002 to reach a peak of 3.8% by end 2003, and that period coincided with a bearish phase for equities. Since then, from early 2003 till the present days, the spread has been on a downtrend. The spread has stayed between 1.6% to 2.0% for the last few quarters. I believe the market is in for a continuance for a bullish phase for at least another year as I would not get edgy or want to quit equities until the spread rises above 2.5%. Once it starts rising, the trend is likely to continue speedily in that direction.
This rule of thumb is worth years of investment losses, a great big picture tool. If we stay true to this rule, you might miss out on the last 10% rally of a bull run but you will save yourself the 30%-40% in correction. The rule also works for spotting end of a bear market. Generally, the spread rising above 3.5% would signal an end of a bear market phase - though at a spread of 3.5% or higher, nothing much will look good, that is why it is so difficult to spot trends turning. Have a nice weekend. Oh, btw, the current spread is around 1.65% and does not look to be trending higher at all. Hence, despite all the worries over oil, inflation, fed funds rate hike, commodities prices, Middle East situation, China's excessive growth and surpluses, the unstable US dollar, etc... the prognosis is for a pretty good bullish phase for sometime still for global equities, just have to ride out the inevitable minor turbulances of over-exuberance of a bull market. We are in a bull market already for the past 16 months, in case some of you have not noticed it!!