7/27/2007: Tighter Credit Conditions Spilling Over to the Equity Market
The sell-off in credit that began in June has accelerated in July and has finally started to spill over to the equity market. The option-spread to Treasuries on the Lehman High Yield index has widened dramatically over the last two months. On June 1, the spread on the index reached a record low of 2.33%. Since then, it has increased 75% to 4.08%, the highest level since May 2005. Yesterday alone saw the spread spike by more than 40 bps. The credit spread on the Lehman High Yield index remains below the historical average of 5%. Using the historical average default loss of 3%, high yield bonds are priced to provide a 1% return premium to Treasuries. That’s below what they have realized historically, but one could argue that it represents fair compensation for the risk incurred. Still, we would avoid high yield bonds at these spreads. We would not be surprised to see default losses significantly exceed the historical average level in the