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5 Key Credit Metrics For Investors Of All Stripes

Whenever the market gets into a funk like it is now, too many investors seem to lose their bearings. Valuations are being reset. Long-term support levels are no longer "supportive." And of course, the Fed appears to be completely lost. Clearly, investors are faced with many challenges right now, the least of which being fear in the marketplace and the "hope" that things will settle down.

There's an old saying out there which we have taken to heart: When in doubt, look about. When nothing seems to make sense, we always look to the credit markets for guidance. After all, our economy moves on credit - either the extension of credit or the tightening of credit.

In the charts that follow, we look at 5 key credit metrics which put a lot of the fear and uncertainty into some perspective. To be sure, there are plenty of other charts out there, and we could fill a room with them. For now, at least, we'll start with these.

Figure 1 - High Yield Spreads versus Equity Volatility

There has long been a high degree of correlation between high yield risk spreads and equity volatility. In fact, this relationship holds true regardless of which direction the market is headed. So when you think about it, how often do you see equity and fixed-income investors looking at the same data and generally drawing the same conclusions?

Because risk spreads and equity volatility aren't always in total sync, it's useful to follow the conformational trends here. Indeed, equity volatility can often spike without any immediate follow through in credit markets, and vice versa. What we saw in August represents a classic case of the credit markets getting way out in front of equities but eventually the markets brought this relationship back into sync.

Figure 2 - TED Spreads

Spreads between Treasuries and Euro-Dollars represents an important measure of financial stability. In that regard, we like to follow TED spreads, which reflect the difference between 3-month LIBOR rates and 3-month Treasury rates. When TED spreads remain fairly stable in a range of 20 to 30 basis points, the financial markets seem to have sufficient levels of liquidity. However, we have seen a bit more volatility in TED spreads, where spreads have risen modestly above 30 basis points reflecting, we believe, a number of reasons including elevated risks spreads and some volatile movements in volatility itself. To be sure, TED spreads at current levels are not sounding the alarm bells, but they need to be watched very closely.

Figure 3 - Spreads between BB and BBB yields

Spreads between effective BB interest rates and effective BBB rates have widened about 40 basis points in the last couple of weeks reflecting, no doubt, the correction in equity valuations and the similar moves in fixed income. While the shift is one we're glad to see, we're not sure that 140 basis points between high yield and investment grade securities represent enough of a correction. Quite frankly, we'd rather see the spread widen to about 200 basis points before we can say this correction has done its job.

Figure 4 - Consumer debt service payments versus disposable personal income

Consumers have clearly been through the proverbial ringer during past three business cycles, but it's not hard to understand given our consumption-driven economy. To that end, consumer leverage represents one of those "hot-button issues" which investors love to worry about. Rather than look at absolute levels of consumer debt and income, we prefer to track the consumer's ability to service their debt obligations relative to disposable personal income. After all, this measure of liquidity is what lenders really care about. Even if you're up to your eyeballs in debt, if you can meet the monthly servicing costs, the banks are happy.

Over the past two cycles, consumer debt service payments have declined quite dramatically. In fact, after peaking at 6.71% of disposable personal income in Q4 of 2001, this measure fell to a low of 4.88% in Q4 of 2012. To be sure, lower interest rates certainly influenced the 12-year decline in debt servicing requirements, but so too did the recession that followed the tech bubble and the financial crisis in 2008. As of the latest data for Q1 2015, debt service payments now account for almost 5.3% of disposable personal income. With continued sluggish economic growth and dis-inflationary pressures keeping a lid on higher borrowing costs, we wouldn't worry too much right now. When and if the debt service ratios reaches 6%, that would get our attention for sure. We like to note here that this indicator is something of a "late-stage" indicator. Accordingly, the consumption model which drives the economy appears to be standing on solid ground right now.

Figure 5 - 2-year Treasury rates

The rates on 2-year Treasuries have been receiving an awful lot of attention these days. And for that, we can thank the Fed for their "on again - off again" policy views. Whether or not the FOMC hikes in October, December or even next year is anyone's guess. What we do know is that 2-year Treasury rates are extremely sensitive to changes in monetary policy. Indeed, most of the Fed's "jawboning" in 2015 was crafted for a single purpose: prepare the markets for tightening. So in that regard, we'll be keeping a close eye on movements in 2-year Treasuries.

In spite of all the market gyrations, market liquidity seems to be holding up fairly well based on historically low TED spreads. The spreads between BB and BBB corporate has seen a bit of rationalization, which represents a net positive in our view. And the fact that this rationalization is occurring at a reasonable pace is also encouraging.

Investors should also find comfort in knowing that consumer debt remains under control with debt service requirements still near all-time lows relative to personal disposable income.

About the only thing we can say regarding Fed monetary policy is that investors shouldn't dwell on it. Should the FOMC act on a 25 basis point move, that's about all they're going to get. The global markets are in no mood for any rate hikes. Indeed, the Fed's time might be better served in figuring out what's happening with inflation. And while they're at it, maybe the Fed could begin to work on a more credible definition of what actually constitutes "full employment."


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