Monthly Archives: September 2012

QE3: a quality spread perspective

While markets/Wall Street players are positively surprised by QE3 and most economists claim they have (more or less) predicted the event, it sparks numerous debates around how much QE3 could support the real economy.  A quality spread perspective is quite interesting. Instead of touching on the amount of benefit to borrowers, it argues that the benefit would be asymmetrically distributed, with high-quality borrowers (AA/AAA) being benefit a lot more than lower-quality borrowers (BBB).

Look back the history…

US BBB corporate spread and AAA/AA corporate spread traded at 234bps and 77bps, respectively, as end of August (the Y axis in the figure is in percent). It is compared to a 15-year historical median of 179bps and 88bps. In other word, lower-quality (albeit still investment-grade) corporates are taking a higher spread than what the history indicated while the best quality ones are taking a spread close to history. This also causes the quality spread – currently 157bps, the difference between BBB spread and AAA/AA spread – to be higher than a historical median of 88bps.

However, there are three things worth mentioning that may explain the situation:

a) Comparison with the past 15 years might not be fair. Although the period covers an unprecedented crisis that once pushed spread to an extra-ordinary high level, most of the period is relevant to Great Moderation which was also unprecedented and contained spread at a exceptionally low level. Net-net, it should be reasonable to say going forward the spread should be higher than the 15-year median. In other word, the AAA/AA corporate spread is indeed quite tight for the moment. (Some people tend to use disastrous factor to explain the low spread in high-quality bonds, which sounds very reasonable, but it goes beyond the current blog entry and is pretty hard to estimate the magnitude). That supports the argument of asymmetric benefits.

b) The figure shows the spread, not yield which is the nominal borrowing cost. With base rate going at an all-time low level, the corporate yield – by looking at BBB corporates – is already at its 15-year low. It is worth mentioning that, given central bank intervention artificially press down the base rate, the spread (over base) is artificially widened.  Net-net, the corporates do feel the benefit of lowered borrowing cost in the face of zero interest-rate policy.

c) Supply of corporate debt did increase after the crisis as corporates did take the advantage of lower borrowing rate, which supports the spread level instead of tightening it.  In other word, the increased supply may reasonably explain the higher BBB spread relative to history.

Going forward…

Quality spread, like most other financial market variables, can be interpreted in different ways by people. Technicalists consider it as measure of market sentiment/risk aversion, while fundamentalists regard it as risk premium which reflects the risk differentials between borrowers. QE3 may either increase market risk appetite – a technical perspective – or reduce the credit risk of lower-quality borrowers – a fundamentalist perspective – or both. Whatever happens, the quality spread should tighten. In my opinion, the technical element might act a bigger impact than the fundamental element if the quality indeed tightens as expected. The Fed raised QE3 because it was pushed to the corner by the deteriorating fundamentals most of which, ironically, cannot be well tackled by the Fed only. That made me to conclude that, while QE3 should alleviate the asymmetry of benefits to borrowers facing low interest rate, I suspect not many lower-quality borrowers can truly take advantage of it until fundamentals really improve.

As a separate note, interestingly, many emerging market governments are already voicing their concern about the negative impact of QE3 on their own economies, with higher commodity price and currency appreciation. I think they are justified to do so, as the benefit of QE3 – better fundamentals and higher aggregate demand – comes in the medium term while its cost is felt in the near term by augmenting the financial flows between countries and assets.

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