Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Q2 2020 hedge fund letters, conferences and more
The current environment may be more uncertain and riskier than any we have seen in our lifetimes. Yet, corporate bond spreads say the future has never been more certain.
I recently wrote that line in The Markets Are Sending Confounding Messages. The article discusses a “metaphorical fog,” induced by central banks. The fog envelops all market signals and, in the process, takes away all means of orientation. Investors, unaware of the fog, investing aggressively with little concern.
This article examines the corporate bond fog. Corporate yields are priced for perfection while the economy languishes in what some describe as depression.
Quantifying warped perceptions
There are many ways to quantify risk. For this article, I use the economic policy uncertainty index (EPUI).
The EPUI is comprehensive, as it uses three distinct underlying components to measure the degree of economic uncertainty. Per the organization, its methodology is as follows:
To measure policy-related economic uncertainty, we construct an index from three types of underlying components. One component quantifies newspaper coverage of policy-related economic uncertainty. A second component reflects the number of federal tax code provisions set to expire in future years. The third component uses disagreement among economic forecasters as a proxy for uncertainty.
A high index level denotes more uncertainty, and conversely, a lower level reflects more confidence.
The index and its history can be found and downloaded on the St. Louis Federal Reserve’s web site.
Corporate bond spreads
The opening quote was from a section of the mentioned article where we discuss the gross mismeasurement of corporate bond risk. Specifically, corporate versus U.S. Treasury bond yields are at minimal levels, reflecting a high degree of certainty and strength in the economy and financial conditions of corporations.
Yet over 90% of the world’s economies are in a recession. Second-quarter real GDP fell by an annualized rate of 32.9%. The last such decline was during the Great Depression.
While recovery may take hold, there is no guarantee it will last. Recovery has been fully supported by grossly unsustainable fiscal and monetary actions. There are serious questions as to whether these operations can continue.
Needless to say, confidence in the ability of corporations to thrive is misplaced. Historically, economic certainty and corporate spreads tend to follow the same path. Today, they are moving in the opposite direction.
To quantify this irrational deviation, I compared the EPUI to BBB-corporate/Treasury yield spreads.
The first graph below compares EPUI to BBB spreads. The higher EPUI, the more uncertainty. Similarly, the higher BBB spreads, the more investor insecurity is priced into bonds.
The second graph divides BBB-rated spreads by the EPUI to provide a comparative ratio. Traditionally, in environments like today, the ratio rises. Conversely, in times of a healthy economy with solid investor confidence, the ratio is low.
The current level of economic uncertainty in EPUI dwarfs prior extremes. BBB spreads are near historic lows. As a result, the ratio of the two rests at the lowest level in 20 years. This reading is untenable.
If the Fed were not rigorously manipulating yields, we would expect the ratio to be at the upper end of the graph. Yields should easily be into the double digits.
Read the full article here by Michael Lebowitz, Advisor Perspectives
