Fear Factor at All Time High

By The Curmudgeon

1.  VIX and TED spread at extreme high levels for many days

2.  T bill yields <1% for extended period of time

3.  Japanese Yen at .92 makes 11 year high against US $, which itself has major rally against all other currencies (carry trade unwind, deleveraging, fear buying)

4.  October 10 closing low tested and broken several times after Oct 13 sharp rally.  Normally an intermediate low, punctuated by a sharp rally, is not tested for several months.  This time it was a few trading days! This shows total lack of confidence in the staying power and failure of any rally (the Oct 13 rally was a 1 day wonder - 2 days later the DJI was down 733 points). 

5.  High yield to Treasury yield spread at record high (19% points), while defaults are only 3.2% at this time.


From the Oct 25th  Financial Post:



Junk bond yields have blown out to extreme highs. The iTraxx Crossover index, which represents the cost of insuring junk-rated companies, hit a record high on Friday (see FT article below), eclipsing its previous high on Wednesday

The cost of insuring against junk defaults is such that a buyer would break even if two-thirds of the companies in the index defaulted with 40% recovery rates, according to the Financial Times. The high-yield default rate through September is only 3.2%.

Access to credit is greatly diminished for corporations with near-term borrowing requirements. This factor, along with weak earnings in the near term, will surely cause default rates to rise over the next year.


To get to default rates currently being discounted by the high-yield bond market, the U. S. economy would need to endure a very long and nasty skid. To add a little perspective, in the last economic downturn in 2001 and 2002, the high-yield default rate shot up to 12.9% and 16.4% in each year respectively.


From Oct 25th Financial Times:


Credit spreads widened sharply as fears of corporate default intensified. The iTraxx Crossover index of mostly junk-rated credits climbed above 900bp to a record level.


As most people know, high grade muni bonds yield= 142% of the yield on Treasuries, that is they yield 42% more (Muni Bond Buyer Index-Treasury Bond yield).  In almost any other period of US financial history, Treasuries yielded more than Munis (which are national tax free). 


One would suspect that the muni default rate is high, but it is not.  Last Wed I was on an Oppenheimer muni bond conference call where they stated that the default rate on the CA Muni Bond portfolio was 0.02%.  That is a negligible/ nil default rate, yet the fund is down almost 30% YTD and was also down last year.


Perhaps the most absurd aspect of the muni bond collapse is that bonds with insurance against default are selling at LOWER prices than bonds with no insurance.  In other words, insurance is subtracting not adding to the value of the bond.  How can that be?  If the insurer went bankrupt the buyer would be no worse off than if he did not have the insurance.  But instead the insurance produces a lower valuation.  I hold a big position in Eaton Vance National Muni (EANAX) which has over 1/2 its portfolio in insured AA munis.  But it is down more than comparable or lower quality muni bond funds with no insurance


Go figure!


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.