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What Are The Credit Markets Telling Asset Allocators? 

October 21, 2015

Toby Nagle, Seeking Alpha

Credit spreads - the additional yield promised to investors over and above the yield offered by similar maturity government bonds - can contain important information about investors' expectations regarding risks to corporate solvency, and the economic cycle more generally. Rising credit spreads can also reveal strains in the financial system that are only later reflected in equity market valuations. As such, it is worth asking what the substantial rise in investment grade and high-yield credit spreads over the past 18 months (Exhibits 1 & 2) means for investors.

Credit spreads compensate investors for a combination of underlying corporate credit risk and illiquidity risk. We have written before about a technique that is used by our investment team and the Bank of England to split credit spreads into these two components. Our analysis suggests that there has been neither an increase in theoretical liquidity risk premia embedded in credit spreads nor an increase in empirical measures of illiquidity over the past 18 months. As such, it would seem by the process of elimination that the increase in credit spreads really is about an increase in perceived credit risk.

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