Finance Basics, part 5

The fifth point and fourth implication of market efficiency is to understand credit risk. U.S. government bonds are default-free, since they have a monopoly on the money supply. Despite deregulation in many areas, very few governments have given up their monopoly rights to print money as the legal medium of exchange. However, corporate borrowers have no such access to the money supply. They have to earn the dollars to pay off debt obligations the same as everyone else. Consequently, there is default or credit risk attached to corporate bonds.

We can look at the amount of default risk attached to corporate bonds by looking at the yields, or market interest rates, on lower- quality corporate bonds and comparing them to the yields on U.S. Treasuries. This yield spread reflects the default risk attached to corporations and both the likelihood of the company defaulting and the expected payout should the firm default. By tracking this yield spread through time, we get the market’s indication of the likelihood of corporate bankruptcies.

For example, at the top of the business cycle when the economy is booming, most firms are profitable and can survive; this is just a variation on Ronald Reagan’s “Rising tide raises all boats.” In this case, there is relatively little risk attached to corporate debt, and we tend to see default spreads narrow as investors become convinced that good times will continue. On the other hand, once the economy starts to slow, corporate profitability starts to decline, and competition becomes more acute. In this case, default spreads start to widen as investors sell corporate bonds due to their higher default risk, forcing up the yield or market interest rate on corporate debt. A “flight to quality” always happens during a slowdown, and the severity of its effects can be seen in the default spread.

By understanding how credit risk varies with the business cycle, we can understand how the market rates the probability of a firm’s defaulting on its obligations. By looking at the aggregate data, we get an indication of the short-run severity of a recession or boom. This information is particularly useful when combined with the interest rate data indicating where the market expects interest rates to go. Want to know where we are in the business cycle? Listen to the market.

In terms of what the capital market can tell us, there are clear messages. The term structure of interest rates tells us where interest rates are expected to go. The interest rate difference between real return and nominal bonds tells us where the capital market thinks inflation will go. The forward foreign exchange rate tells us where the foreign exchange rate is likely to go. Finally, the spread between corporate and government bonds tells us where the market thinks default risk is going and gives a good indicator of where we are in the business cycle.