Interpreting the Surge in Bond Protection Prices

One corner of the credit market is showing some signs of angst from U.S. equities’ roughest October since the financial crisis.

As shown in the LPL Chart of the Day, the price of U.S. credit-default swaps (CDS), or a measure of the cost of insuring against default on a bond, has risen to its highest level since December 2016 for both high-yield and investment-grade bonds. Higher CDS prices indicate increasing demand for bond protection amid a bout of U.S. equity volatility.

Cost of Bond Insurance Jumps to Highest Since December 2016

While the jump in CDS can be perceived as a warning of a credit event, other measures of corporate-bond stress signal differently.

High-yield and investment-grade spreads, though notably higher this month, are still low compared to history and contained relative to Treasury yields, suggesting investors are confident that corporations are able to service outstanding debt. Interest coverage ratios for S&P 500 Index companies are still significantly higher than they were before the financial crisis, and corporate profits are on track for the second quarter of double-digit profit growth. The TED Spread, or the difference between 3-month LIBOR and the 3-month Treasury yield, sits near a 15-month low, reflecting the lack of stress in bank credit relative to government debt.

“Companies’ balance sheets remain strong, thanks to solid economic growth and strong corporate profits,” said LPL Chief Investment Strategist John Lynch. “Overall, our cautious outlook on fixed income hasn’t changed. Yet, bonds remain an important part of diversified portfolios, as they provide liquidity, income, and can help mitigate risk during times of equity market weakness.”

Higher long-term rates could be a source of the nervousness in corporate bonds, especially as the 10-year Treasury yield hovers near a 7-year high. However, we don’t expect rates to climb much higher from these levels amid contained inflation and relatively low rates overseas. We expect the 10-year yield to trade near the upper end of our original 2.75–3.25% year-end 2018 forecast.

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