As the S&P 500 ($INX) flirts with highs last seen in October 2008, the credit markets have been on edge, and the perceived risk of default is risen to its highest levels in a month -- a time when the S&P was 50 points lower. Since reaching a low point the first week of August, the cost of insuring against default on a basket of investment grade-rated debt has risen 15 percent, and the same measure for lower-rated "high-yield" or "junk" credits jumped 16 percent, according to data from Markit CDX indices. Similar indices tracking subprime mortgage-backed securities and commercial MBS have also fallen sharply in the last few weeks.
The conflicting signals -- either the stock market or bond market must be wrong -- are a sign that the massive rally in equities could be drawing to a close. The bond market is traditionally viewed as the more prescient forward indicator, and as credit investors show more risk-aversion (Treasury yields have also dropped in the last week) while stock investors bullishly march on, the odds of a negative shock jump. What stocks are most at risk?
One way of determining the potential for negative "surprise" events is to look at the difference between a company's credit rating and the level that credit default swaps trade at. The CDS market can indicate that the ratings agencies have misjudged risk by charging more for protection than a comparably-rated credit -- for example, a company rated "A2" might have its CDS trading at the same price of other credits rated "Baa2," suggesting there's a greater-than-expected chance of default.
For a more concrete explanation, I ran this exact same test -- comparing given ratings to the CDS levels -- in July 2008. The two largest negative ratings-to-CDS discrepancies among Dow Jones Industrial ($INDU) components were General Electric (GE) and AIG (AIG). Among the twenty largest components of the Financial Select Sector SPDR (XLF), the results -- in order -- were Wachovia, Morgan Stanley (MS), Citigroup (C), and AIG. Needless to say, the CDS market has shown some predictive power in the past.
At present, out of the twenty largest XLF components, the company with the largest difference between Moody's (MCO) rating and the CDS-implied rating is insurer Metlife (MET), at -7. The company with the lowest implied rating is Citigroup, at Ba2, or two notches below investment grade. Citigroup is also tied with Morgan Stanley, U.S. Bancorp (USB), BB&T Corp. (BBT), and Goldman Sachs (GS) for the second-largest ratings differential at -5. While the markets have had time to settle down, and the ratings agencies have had time to make belated downgrades, there's still plenty of concern by bond market participants over the safety of the financial sector.
James Cullen edits and writes at CollegeAnalysts.com. He is the Vice-President of the Boston College Investment Club, which owns GE and GS, but has no personal position in the stocks mentioned above.