What happened? Just a few weeks ago, the bond market was flush with liquidity and sub-prime was an isolated problem. Now that seems like a long time ago and a market far, far away.
First, let's review some facts.
- The economy is still growing at a fairly strong pace outside of housing. Excluding bond market activity, there is little evidence that housing is causing problems in other areas of the economy.
- The only segment of the bond market where there have been actual disruption of cash flows remains the sub-prime ABS and ABS CDO markets.
- Both corporate defaults and corporate leverage remain low by historic standards.
- The factors causing liquidity to be so plentiful are still in tact, particularly over savings in Asia, easy money from Japan and China, and large cash flows to hedge funds and private equity.
Given these three facts, there are two logical explanations of for the violent collapse of credit spreads.
First, the bond market is anticipating that some or all of these factors will change for the worse. Consumer spending will finally slow, corporate defaults will rise, and foreigners will find U.S. investments less attractive.
Alternatively, you could argue that this is mostly technical. There is an extremely heavy high-yield calendar over the next several weeks. That coupled with a general discomfort with historically tight spreads and fear over sub-prime contagion causes real money accounts to back off corporate bonds entirely. Each basis point of widening seems to confirm the theory that spreads are "returning to normal" and causes more people to sell corporates.
I'm working through which scenario I find more credible. My instinct is the later, but the former can't be dismissed. Anyway, a key thing to remember is that corporate spreads will not rebound as quickly as they widened out. No matter what scenario you side with. Because corporate bonds are negatively skewed (i.e., your potential loss is always greater than your potential gain) fear will always linger in that market. This is as opposed to stocks, where greed can cause a more rapid rebound. More on this idea soon.
So I'd say the best case scenario for the short-term, meaning next couple weeks, is that corporate traders manage to feel out where there is an actual market, some bidders emerge, and the corporate market stabilizes. If this happens, and the stock market also rebounds, then corporates become a buy, on the theory that corps will catch up with stocks.
The worst case scenario? Uhhh...