Long corporate debts, short treasuries - what credit spread says

With world stock markets lost almost $30 trillion in 2008, and investments across other asset classes except US treasuries all plummeted, everything looks cheap now except treasuries. But one investment standing out is corporate debt, investment grade. Although its yield has come down in the last three months, it is still not too late to get in.

But the dramatic spread widening in corporate credit right now seems really abnormal. The current corporate debt spreads have blown out to an astonishing extent, implying cumulative default rates of 30% for investment grade, according to HSBC calculations. The history has never witnessed such a high level: even during the Great Depression, the default rate was only about 20%, which also includes junk bonds. The investment grade bonds should have had much lower default rate.

Of course corporate credit staying so cheap may be because hedge funds and banks are deleveraging. In the process, corporate bonds used as collateral in exchange for cash are less needed. If those funds and banks continue deleveraging, then corporate creadit may stay cheap longer. Yet, with thousands of hedge funds having blown up in 2008, and banks having dramatically reduced leverage, the process seems more likely close to an end. At least, the worst period seemed already behind us.

So it appears a pretty good opportunity to buy investment grade corporate debts.

One risk to the investment thesis of long investment grade corp bonds only is that yield could go much higher, thus generating capital loss down the road. The probability is not very low. At this point, more people are worried about deflation rather than infation, and treasuries yield is at historical low. Assume the US government is to issue trillions of treasuries next year to finance the bail-out, the bond market could be flooded, leaving emerging market and corporates struggling for finding investors. The yield has to go up then. Current money-easing environment may also facilitate another round of inflation, which should also prop the corporate bond yield.

So a better investment thesis would be long investment grade corporate bonds and short US treasuries. Because the liquidity premium is so high in the market, investments have kept flown to treasuries market, bidding up the prices to an unsustainable level. At one time, even the nominal yield was negative for treasury bills, not speaking of real yield. So with US treasuries currently over valued, its yield having to go up next year after issuing hundreds of billions of new instruments, being short US treasuries seems an excellent candidate to the above relative value strategy. No matter both yields going up or down, as long as the credit spread not making another historical high, you would make money.

One practical solution for retail investors is through low cost ETF. For example you can long LQD, short IEF.