In ordinary times, stock and bond investors see pretty much eye-to-eye when sizing up the risk of corporate default. When bond investors get nervous about a default, the stock price gets whacked because shareholders are the first to be wiped out in a bankruptcy. Lately, though, bond and derivative investors have been far more pessimistic than their equity brethren. If they're right, stocks could be in for big trouble.
Recent history supports the bearish view. Bond and derivative traders, who tend to focus on balance-sheet risks and ignore management happy talk, were way ahead of stock investors in picking up on problems in the subprime mortgage market and elsewhere. And they remain more bearish. Stock prices—while 14% off their October, 2007, peak—are still above where they were as recently as the summer of 2006. Meanwhile, corporate bond yields are 2.5 percentage points above yields on Treasuries, the highest level for this anxiety indicator since its inception in 1996. "The credit market is showing significantly more fear than the equity market. There's a gaping hole between them," says Tim Backshall, chief strategist of Credit Derivatives Research in Walnut Creek, Calif.
One of the most sensitive gauges of risk is the credit default swap market, and it's flashing red. The swaps are contracts on the possibility of a corporate default. One party buys protection from default for an annual fee, while the counterparty that collects the fee commits to paying in case of a default. If the cost of protection goes up, it means the shares are in some danger, even if the stock price doesn't show it.
On Mar. 4 the average cost of protection against default, as measured by a basket of swaps on 125 companies, hit a record. That's according to the benchmark Markit CDX North America Investment Grade Index. Financial companies have a 19% weighting in the index. It cost more than 1.6% of the bonds' face value per year to obtain default protection on the bonds for five years, up sharply from just 0.3% per year for a similar basket a year ago. Even if the companies in the basket don't default, a big decrease in the value of their assets would obviously hurt share prices, says Brian Yelvington, senior macro strategist at CreditSights, a capital-structure research firm in New York.
A recent example of the swaps market's prescience is the case of insurers American International Group (AIG) and MBIA (MBI). Swaps turned skittish about their prospects long before the stock market caught on to the companies' problems. The cost of default protection on MBIA bonds soared last summer and fall at a time when "the story from the equity market was that MBIA was going to benefit from the turbulence in the credit market by insuring more bonds," says Gary Kelly, head of research in the New York office of Tradition, a Swiss-owned broker for big dealers.
Higher prices for default protection aren't always bad news for equity investors. Sometimes they're a sign that the swaps market is expecting a leveraged buyout or an acquisition that would load the company with debt but reward current stockholders. Kelly says that's the case with LBO candidates Clear Channel Communications (CCU) and Bell Canada parent BCE, as well as with Marriott International (MAR), which is frequently the subject of takeover rumors. And occasionally it's the credit default swap market that's more optimistic. The swaps market was ahead of the stock market in perceiving the good prospects of Occidental Petroleum (OXY), whose shares fell in January but have since rebounded.
Average investors can't easily get their hands on credit default swap pricing for individual companies, but data for market indexes is available daily at www.markit.com. Whether you track the numbers closely or not, it pays to keep the big picture in mind—namely that right now the stock and bond markets have sharply different views about where corporate fortunes are headed. And lately the pessimistic fixed-income market has gotten it right.