Credit spreads too thin?

John Mauldin’s latest Thoughts from the Frontline Weekly Newsletter featured an excellent article by Michael Lewitt of Harch Capital Management.

The subject was the state of credit markets. This may seem like an unimportant subject to many observers, but it impacts the financial markets and global economy in ways most don’t grasp.

Specifically, the article talked about how credit spread are still very thin compared to historical average. What are credit spreads? Generally, they are the difference between the yield on a risky credit (corporate debt, mortgage backed securities) compared to a non-risky credit, which is considered to be a government bill, note or bond depending on the maturity of the bond.

When the credit spread is wide, market participants are worried about credit risk and are demanding a large spread over risk-free securities. When the spread is thin, the market is unworried about credit risk and is demanding very little compensation over risk-free securities.

Historically, credit markets go through swings of greater and lesser toleration for credit risk. Typically, the market gets complacent after a long period of low defaults and then gets over-concerned after a short period of high defaults.

Right now, we have just recently come off some of the lowest credit spreads in history. The normal result is a market shake-up that returns low credit spreads to high credit spreads. These can be very disturbing events, as it was in 1998 when Long Term Capital Management collapsed.

Credit markets tend to reflect the market’s toleration for bearing risk. When the market is complacent, it signals trouble may be ahead. When the market is worried, it frequently signals a great time to invest. In my opinion, we are on our way from complacent to worried, and that means opportunity lies ahead.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.