Look Out for Rising Defaults

One of the most useful of economic indicators is the credit spread, which measures the difference in lending rates between corporate and government borrowers. A relatively narrow spread shows that investors see little difference in risk between these two types of borrowers, while a widening spread means that corporate credit is seen as a less certain alternative to rock-solid U.S. Treasuries.

As one would expect, during periods of economic uncertainty credit spreads tend to increase. Indeed, after years of near record-low spreads, the difference in yield between high yield bonds and Treasuries of the same maturity have risen to levels not seen since early 2003. Traditionally, spread widening is usually accompanied by rising default rates among high yield bonds, but so far this year bankruptcies have only risen by a tiny amount. So what gives?

First off, credit spreads aren’t just indicative of investor uncertainty in the corporate sector; it is also a gauge of the unwillingness of banks to lend money. But as the economy continues to slow, there is little doubt that the number of failed companies will increase. This is especially true with the recent changes in the bankruptcy laws, which now require that vendors doing business with a company within 20 days of a Chapter 11 filing be paid in full before the company can exit protection. This takes away liquidity from troubled companies, which makes getting financing more difficult.