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Guest Post: Credit Spreads In The New Normal

Tyler Durden's picture


Submitted by JM

Credit Spreads in the New Normal

At its very core, to price something complicated, you lay the most similar liquid asset you can find next to it that has a liquid price.  You deconstruct the liquid one by its risk premia, and then you reconstruct the one you are trying to price by applying suitable risk premia to it.  The output is fair value. 

All the talk of “Japanification” is just a variation on this theme at a pretty remarkable order of complexity.  Call it modeling, call it storytelling, whatever:  one compares an economy going through a multi-year banking crisis with one that is just a few years into a banking crisis.  Compare trajectories, similarities, and differences.  Then figure out what matters and what doesn’t in a macro-sense.  One has either past observation to understand reality, or rely on dumb luck to understand future events.     


  • High yield spreads are near the top of the list of mean-reverting things in the new normal.  I think only vol is more mean-reverting.  The new normal accelerates compression speed.
  • Watch out for paying too much for higher credit risk bonds in a deleveraging cycle.  Nothing new normal here, this is just like always.  But the new normal does make blow-outs bigger.
  • Top-tier IG credit will trade tight and at times outperform government securities (red arrow) even in times of crisis after multiple boom and bust cycles.  This is the new normal. 

Japanese 5Y Corporate Credit Spreads over JGBs and Event Overlay, 2003-Oct 1, 2011

The takeaways are rules of thumb, and there is an exception to every rule, so take this as impressionistic and not doctrinaire.  The jist of the new normal is higher vol peaks and faster mean reversion due to persistent boom and bust cycles.  This isn’t due to government policy.  It is due to government policy bumping the ceiling of feasibility and losing effectiveness.  Things aren’t falling apart:  it is just that the true nature of risk can’t be suppressed indefinitely.

2007 was quite a year for AAA IG.  For a while, they had a negative yield spread to matched-maturity JGBs, then inflation took its toll.  Policy tightening actually benefitted top-tier spreads.  Until Fukushima a few months ago, Japanese AAA carried a zero spread.  I conjecture this is due to the rising credit risk in JGBs offsetting the interest rate risk in AAA corporate.  Another way to say this is that interest rate risk evolves into credit risk.  A simple illustration of this:  a JGB rate from 2% to 4% may not seem much, but it doubles the interest burden on new debt issuance.  This is the essential logic of “DV01” arguments when you hear them.            

The other ting to notice is that there is a strong differentiation in credit risk that develops after a banking crisis.  Comparing Japan Credit Ratings, LLC (JCR) AAA and AA credit and BBB rated credits, we see big differences in volatility—huge spread blow-outs in lower credits.  These are tradable but credit vol is slower moving and very dependent on monetary policy stance.  Note that October 2011 bond yields look like BBB Japanese corporate bonds are rich and have nowhere to go but down on a yield basis.

Term Risk Matters:  One year maturity spreads on all credits were tight most of the time.  The 2008-2009 spread blow-out effect was even more pronounced at these maturities than at mid-curve, simply because people wanted shorter maturity government paper in the melt-down.  Lower tier credits also haven’t recovered like five year bonds have, carrying a persistent spread premium.

Japanese 1Y Corporate Credit Spreads over JGBs, 2003-2011

Objection:  Is this behavior better explained by some “Asian Characteristics” than boom and bust cycles?

It is reasonable to question if Japan is a close proxy at all:  all this could be just some idiosyncratic features that make this spurious.  There’s a possibility of this, but I don’t really think so.  First, people are people no matter where they live, and people respond to incentives of risk and reward.  There are different institutions, but there are also commonalities in central banking, demographic trends, among other things.   

Second, it appears that this behavior was specific to Japan, because a country with similar institutions and even more granular similarities have credit markets that didn’t act this way at all.  In Korea one observes a positive spreads for all bonds, and a consistently wide spread between AAA/AA and BBB credits, well over 200 bps over the period.  There was also much stronger cointegration between top tier credits (again proxied by credit rating classes) and lower tiers credit classes:  they moved together with respect to government security yields. 
Have a look at the 5Y maturity.  Note that this isn’t the belly of the curve in Korea, because the bulk of issuance go no further than this in term. So think of it as more like the long wing of the curve where there is some liquidity.  It is true that top-tier credits were quick to recover, but that is everywhere in all times. Risk aversion in lower tier credit is more persistent in the Korean case over the whole time period.

Korean 5Y Corporate Credit Spreads over KGBs, 2003-2011

Lessons for Chimerica

A banking crisis implies easy money, ZIRP, various types of balance sheet expansion, and lower credit quality on central bank balance sheets.  This acts to suppress credit risk, compressing spreads.  This creates “artificiality” in credit market insofar as a central bank is not a natural buyer of higher risk securities.  There will come a time when risk is moved off central books, and markets will have to learn how to re-price risk with no government support.  

Another problem Japan faced in the last decade is fiscal correction.  Whenever recovery began in earnest, the government went into fiscal retrenchment mode to repair its own finances.  Tax hikes and the introduction of new taxes, particularly the consumption tax, made a nation of savers ever more conservative just to avoid taxes taking the economy to a standstill again.  I’m not criticizing: this is just the boom and bust of the matter as government imbalances have to correct. 

The combination of poor government balance sheets and good corporate balances sheets were in the driver’s seat.  Households were squeezed. 

So in the United States, a few years into similar financial problems took on a lot more debt to stimulate a recovery.  Then the government got downgraded by one agency.  And the opposition party is talking about “sensible cuts”.  And the party in power has quietly been proposing a series of tax increases on people with money.  Probably won’t see a consumption tax, but a higher tax on dividends or capital gains fits the MO of the party. 

On top of this, next year has a big refi cliff for lower tier credits and the economy looks set to enter a slowdown.  And we look set for tax increases to shore up just awful government finances.  Boom and bust:  as long as the tax burden doesn’t shift in a radical way to corporates, then the logic of Japanification is essentially intact. 

China looks finally on the cusp of these same problems too, as their government is reaching the limits on what non-performing business and provincial assets it can take order banks to take on book without impairing their ability to finance profitable projects.  Compounding this is a clear Chinese commitment to a rising Yuan policy.  There is a massive manufacturing base that will be made uncompetitive as a result.  Before you know it, China will have a massive banking crisis with which to contend.        


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Tue, 10/04/2011 - 19:32 | 1739511 zorba THE GREEK
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The article talks about the future, but the way things look now, there will be no future.

Tue, 10/04/2011 - 19:40 | 1739534 kito
kito's picture

future is an illusion. there is only now......ohmmmmmmmmmmmm

Tue, 10/04/2011 - 20:04 | 1739593 wang (not verified)
wang's picture

The President of the United State of America, Barack Obama, wants debt collectors to have access to cell phone numbers


(AP) — To the dismay of consumer groups and the discomfort of Democrats, President Barack Obama wants Congress to make it easier for private debt collectors to call the cellphones of consumers delinquent on student loans and other billions owed the federal government.

Tue, 10/04/2011 - 21:41 | 1739811 Long-John-Silver
Long-John-Silver's picture

I don't have a cell phone. If I were given one along with unlimited time I would remove it's battery and drill holes through it on my mill or play "Will it Blend". Why? Your phone becomes the master you can never get away from.

Tue, 10/04/2011 - 21:50 | 1739828 kito
kito's picture

youre starting to sound like disabledvet...........

Tue, 10/04/2011 - 20:05 | 1739602 donsluck
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And the Day After Tomorrow.

Tue, 10/04/2011 - 21:15 | 1739759 Squishi
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The Now is the real illusion, and history is tradition...

Tue, 10/04/2011 - 22:21 | 1739927 jm
jm's picture

Reality is just another model.

Tue, 10/04/2011 - 19:41 | 1739535 malusDiaz
malusDiaz's picture

Want to Occupy Wall Street? Do something about it then:  Withdraw $100 in change...  1c, 5c, 10c, 25c Want to REALLY Occupy Wall Street? Then spread the word, and withdraw $200 in change. There is less then 108$ of change per person in the U.S.A... get it quick.

There is less then $108 in Pennies, Nickels, Dimes, Quarters minted from 1964, per person in the U.S.A Pennies: a $25 brick is worth $12.50 in zinc, and $50 if they are copper!    (too bad it'll take 3 weeks to get them delivered, yes I ordered some.) Nickels: a $100 brick is worth $97 in copper/nickel.

I compiled my own research here:

Tue, 10/04/2011 - 19:57 | 1739581 Stumpy
Stumpy's picture

Do we want to track the "bank run" index then? An ETF?

Tue, 10/04/2011 - 20:20 | 1739633 CapitalistRock
CapitalistRock's picture

Banks are not obligated to give it to you. What sort of silly plan is this? Banks will just tell you 'no' when they run low. What did that accomplish?

Tue, 10/04/2011 - 21:43 | 1739817 Bunga Bunga
Bunga Bunga's picture

Right, in the case they run out of cash the can decide that they are not "obligated". Better get it out now before they decide it.

Tue, 10/04/2011 - 21:48 | 1739825 Pure Evil
Pure Evil's picture



Yup, it's about as silly as saving all your turds so that you can polish them later.

Tue, 10/04/2011 - 21:19 | 1739743 DormRoom
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the new normal is a misnomer.  It's actually the old normal.  TAmerican economic history is filled with  boom-bust sagas. 

Tue, 10/04/2011 - 19:39 | 1739518 Logans_Run
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"Japanification"--is that anything like masturbating? Oh, sorry that is "going japanesa"

Tue, 10/04/2011 - 21:45 | 1739819 Bunga Bunga
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No need to masturbate if you have cash.

Tue, 10/04/2011 - 19:39 | 1739529 Corn1945
Corn1945's picture

The United States situation is vastly different than that of Japan. We are a net importer. We are not a nation that saves. Looking at a chart and punching numbers into Excel clouds the basics of the problem.

The US can't print for long without driving up the cost of essential imports (like fuel) and collapsing the economy. ZIRP is currently destroying more than it is helping.

The Japan comparison is not even close to being correct.

Tue, 10/04/2011 - 19:47 | 1739555 jm
jm's picture

I'm not really concerned about how similar the societies or even how similar the economies are. 

What matters here is how central bank policies in conjunction with loose fiscal policies affect bond yields.



Tue, 10/04/2011 - 19:42 | 1739539 TheSilverJournal
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Don't we have QE3 already? ZIRP + TWIST = QE3 because TWIST is selling short to buy long and ZIRP is 0% short, so the FED must also be buying short, right?

Tue, 10/04/2011 - 20:04 | 1739595 donsluck
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I don't believe the FED has to buy short to force ZIRP, since they set short interest at the banks as part of their "window" operations (direct loans to the banks).

Tue, 10/04/2011 - 19:49 | 1739561 LongSoupLine
LongSoupLine's picture

A good write-up.  However, I would like to see more global political reality injected into this articles ideas as it pertains to what's ahead.

For example, our govt, along with China and others (see: Swissy peg) have just entered an all-out, nuts to the fire, foaming at the mouth currency war.  This will have exponential impacts on much of what was said above.  The main impact will be the "speed" and longevity of these and other unforeseen events.

The "new normal" is a fluid term...first yearly, then monthly, weekly, daily...and now, (as we saw with today's market close)...1/2 hourly!

Tue, 10/04/2011 - 20:16 | 1739625 jm
jm's picture

I don't disagree with you as much as I am not competent to address the issues.

Tue, 10/04/2011 - 21:52 | 1739830 LongSoupLine
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jm, after some thought, I believe it has nothing to do with "competency"...besides, you've proven that with your article.  This is pure timeline fortune telling at it's best from here on in.  I don't believe anyone can foresee what tricks governments, TBTF's and mostly central banking cartels, will pull as the game gets ramped-up into a "currency protectionism frenzy".  buckle-up.  Thanks for the insightful writing.

Tue, 03/27/2012 - 03:37 | 2293619 jaffa
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The financial term, credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk. Thanks.
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Tue, 10/04/2011 - 19:50 | 1739565 ivars
ivars's picture

I made long term EUR/USD prediction (2011-2017) to see if there is some support t her for ideas to understand better the default/devaluation ( Europe) debt deflation/default  ( USA) sequence I have been looking at lately.

Here it is with explanations:

Here just chart:

It does support debt  deflation in the Usa during 2012-2014 recession. QE3 won't change anything, perhaps delay deflation till June 2012.


Tue, 10/04/2011 - 19:51 | 1739568 jdrose1985
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So don't plan on shorting TSYs for the next couple of decades?

Thanks for the submittal. Good read.

Tue, 10/04/2011 - 20:03 | 1739594 jm
jm's picture

You actually do pretty good with HG corporates after the government gets downgraded for its irresponsibility.

Tue, 10/04/2011 - 19:58 | 1739584 Stumpy
Stumpy's picture

Bank Run Index (BRI) is still pretty low. Looking for a peak.

Tue, 10/04/2011 - 20:18 | 1739626 jm
jm's picture

Treasury repo delivery fails are a good indication of things coming unglued.

Tue, 10/04/2011 - 21:32 | 1739796 Stumpy
Stumpy's picture

Ah man! Now I have to use Google again.

Tue, 10/04/2011 - 19:58 | 1739585 sangell
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what was thst song? dust in the wind, all we are is dust in the wind! Yeah, I'll trade you 5 years of my work for a government bond! Sounds fair, if you are an idiot. One day those Bloomberg terminals are going to 'speak truth to power' and on that day you'll realize you know nothing!

Tue, 10/04/2011 - 20:05 | 1739601 jm
jm's picture

Don't hate the player.  Hate the game.

Tue, 10/04/2011 - 20:02 | 1739589 disabledvet
disabledvet's picture

Until Europe I was going to say "there's no deflation like an American one" since we're the only modern civilization to have not only slavery but CHATTEL slavery that treats another human as actual property. These prices can go lower than you can possibly imagine since we are being reminded of it right now. Anywho my counter party to the complexity is the naked American female form. There is nothing that compares. Go ahead...price it.

Tue, 10/04/2011 - 20:07 | 1739607 sangell
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"At its very core, to price something complicated, you lay the most similar liquid asset you can find next to it that has a liquid price"

So you compare a Hyundai dealership with Hummer dealership and since they both begin with the letter H, are both automobiles and the former is liquid you conclude you have a price for the H2 dealership. Brilliant!

Tue, 10/04/2011 - 20:39 | 1739677 jm
jm's picture

Here's what I'm saying.

Old normal:

A corporate bond = a risk free bond + credit risk premium + interest rate risk premium + liquidity premium + residual

In the new normal, AAA corporate bond spreads went negative for a time.  This is wild and fascinating and it throws everything off because it means the credit risk premium is greater for government securities.  Assuming gov paper has no interest rate risk.

In a crisis liquidity is just about everything.


Tue, 10/04/2011 - 22:39 | 1739980 4shzl
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In a crisis liquidity is just about everything.

You got that right.  +1

Tue, 03/27/2012 - 01:57 | 2293539 jaffa
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Credit, in commerce and finance, is a term used to denote transactions involving the transfer of money or other property on promise of repayment, usually at a fixed future date. The transferor thereby becomes a creditor, and the transfer, a debtor, hence credit and debt are simply terms describing the same operation viewed from opposite standpoints. Thanks a lot.
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Tue, 10/04/2011 - 20:21 | 1739631 chump666
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Asian markets looking heavy, they go neg, shows how stupid US markets have become...and they need to be flushed out.

Tue, 10/04/2011 - 20:26 | 1739646 Mike2756
Mike2756's picture

Anyone like the yen up here? Looks set for a decent pullback. I'm looking a ycs anywhere in here.

Tue, 10/04/2011 - 20:27 | 1739653 msmith
msmith's picture

USD Index and the AUDUSD updated in the Market Report Evening Edition.  Both have begun their retracements as expected.

Tue, 10/04/2011 - 21:02 | 1739733 RobotTrader
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You think anyone at the Treasury Dept. is the slightest bit worried about funding deficits with interest rates at 47-year lows?

Tue, 10/04/2011 - 21:07 | 1739746 kito
kito's picture

all the more reason to SPEND!!!!!!!!!!!

Tue, 10/04/2011 - 21:17 | 1739766 jm
jm's picture

Spot on, Robo.  They don't give a crap, nor should they at this point.

ZIRPish interest rates makes the currency a funding vehicle that will always need a hedge.  The hedge is government securities.  This in spite of a rising price of credit risk in Japan and the US.

If this doesn't explain it, then it is one of those absurdities that makes life interesting.

Tue, 10/04/2011 - 21:36 | 1739794 Captain Nukem
Captain Nukem's picture

We'll have fun, fun, fun till the markets blow our T-bills away.

Tue, 10/04/2011 - 21:24 | 1739782 chump666
chump666's picture

Nikkei is down...hahaha so the creditors of the world (Asia) are selling and a manic melt-up by the most indebted nation on Earth.  F*ck wall street, this time when an investment bank goes, it goes, like Lehman.  How the f*ck those a-holes are cutting it is anybodies guess.  They must be leveraged to hell... 

I need a drink...

Tue, 10/04/2011 - 22:23 | 1739933 chump666
chump666's picture

risk aversion coming back EUR/USd sellling, Japan selling.

Tue, 10/04/2011 - 21:28 | 1739786 Captain Nukem
Captain Nukem's picture

You think anyone at the Treasury Dept. is the slightest bit worried about funding deficits with interest rates at 47-year lows?

No more than the citizens of Pompeii on 1 January 79AD.

And they have such a wonderful track record. Didn't Bernanke assure us that the subprime problem was contained?

Thu, 03/29/2012 - 05:10 | 2299893 jaffa
jaffa's picture

The financial term, credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk. Thanks.
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Tue, 10/04/2011 - 21:30 | 1739791 Belarus
Belarus's picture

All I know is that the 1o year declined today while stocks ripped. These market are hugely broken in every way. 

Tue, 10/04/2011 - 21:42 | 1739815 kito
kito's picture

read up on kyle bass.....

funny thing about paulson, unlike burry or bass, is that you just get the sense he wasnt the one to make that housing call...his lack of vision after the collapse is clear evidence of that. burry and bass actually thought through the consequences of the housing bust.....paulson..not

Tue, 10/04/2011 - 22:04 | 1739867 Captain Nukem
Captain Nukem's picture

Very interesting! Bass had better hope that whoever underwrote those CDS doesn't go belly up. But maybe he has already sold some.

Hank Paulson is either completely dishonest or a complete idiot. He made repeated statements in 2007 and early 2008 assuring everyone that the economy was fine, no problems with subprime, etc. On 10 Aug 2008 on "Meet the Press" he stated that there were no plans to inject capital into Fannie or Freedie. On 10 Sep 2008, both went into conservatorship.

As head of Goldman, Paulson argued against any regulation of the CDS/derivatives market. As Treasury sec, he bailed out AIG with no haircuts to the CDS holders, netting tens of billions for Goldman which had purchased lots of CDS betting against many of the products that it had sold to its customers.



Tue, 10/04/2011 - 22:51 | 1740003 ZeroPower
ZeroPower's picture

There will come a time when risk is moved off central books, and markets will have to learn how to re-price risk with no government support.  

Ding ding ding. 

If the market is having such a hard time with issuers in this liquidity-drenched (well, not anymore...) environment.. where must we look to to adequately price risk? Theres a reason why spreads in AAA vs Junk are blowing out - how more of the media hasnt caught upon this fascinates me. They do always say credit is smarter than equities though...dont they.


Also, key point at the end there with China and its coming strong CNY/large CapEx/super unsustainable issues. I dont believe this 2011/2012 dip will be the bursting of China, but i do think we have that to look forward to next. 

Wed, 10/05/2011 - 07:37 | 1740560 jm
jm's picture

If you look at Korea, HG-HY spreads remain wide for a lot longer after a crisis.  Looks like less government steriods keeps people wary/smarter.

Could be something idiosyncratic though.

Wed, 10/12/2011 - 12:04 | 1766048 karmete
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