Corporate bonds

Is there a similar differentiation in the world of corporate bonds? Corporate bonds traditionally traded as a spread to Treasuries; investment-grade issues were quoted as such and even high-yield bonds could be expressed as a measure known as option-adjusted spread (OAS). OAS, expressed in basis points, accounts for all the embedded call, put, and sinking-fund features common in corporate bonds and makes them equivalent to Treasuries.

OAS levels reflect credit stress in the world of corporate bonds. They rise during recessions and during bear markets and fall when the opposite occurs. Yet in an unusual turn of history, they have been in a tight trading range for more than two years.

The reason this trading range has persisted involves a major structural change in the corporate bond market. The advent of credit default swaps (CDS) means bond investors no longer trade the fairly illiquid corporate bonds but buy the CDS instead. A CDS acts much like a put option on a bond — the buyer of protection can put the bond or cash equivalent back to the protection seller at par in the event of a credit default such as a bankruptcy or a material downgrade.

As the bonds remain intact, their OAS remains flat and the action shifts to the costs of the CDS, also expressed in basis points.

We can construct an index of CDS costs for each of the S&P economic sector’s CDS. Just as we did for the relative performance of stocks, we can regress the returns for these indices against the returns on the currencies. A positive coefficient means credit stress rises for the sector as the currency strengthens; a negative coefficient means credit stress falls as the currency strengthens. The results for each sector are displayed.

The results are rather extraordinary. Healthcare is the only sector wherein credit costs rise in a weak dollar environment. Beyond that, there are only two more cases of a weaker dollar causing higher corporate credit stress — industrials with respect to the Japanese yen and technology with respect to the euro.

Several sectors appear to do very well indeed during weak-dollar environments. Basic materials, financials, and telecommunications all benefit when the Canadian dollar firms. Telecommunications also experiences much less credit stress during a strong Japanese yen environment.

And the euro, for all the time and attention devoted to its movements, has no strongly negative relationship with the credit stress of any sector.

If stocks float on a sea of corporate bonds — you will not be interested in buying the stock of a firm whose bonds are in trouble — then we should conclude that a weaker dollar has little negative impact on either the corporate bond market or, by extension, the stock market.

There we have it: The next time a breathless financial pundit proclaims the world did not end that day “in spite of a weaker dollar,” you can smile knowingly. The relationship simply does not exist in the data.