C.M.O. 11.24.2009
Credit Market Overview
November 24, 2009
Whether we are currently in the eye of an economic storm the back wall of which is still lurking with prime residential and commercial mortgage defaults providing the knockout blow to an already weakened financial defense network, or as some say, the green shoots are turning into saplings, stocks have made their run up and credit spreads their run down providing some with reasonable returns for the year.
Transitioning, whether in triathlons or economic cycles is usually the trickiest bit as the old method of conveyance, either by reason or design, will not be appropriate for the next leg of the journey.
Towards this end there has been much written lately on dividend paying equities. The thinking here goes that companies still able to pay dividends after the events of the past two years are well capitalized companies with solid balance sheets and enough cash around to give some back to the investors.
In a switch from the lesser quality names that propelled the broader averages off the March lows Larry Light wrote in the WSJ this past weekend that on a total return basis “payers” outperformed “non-payers” in October and were in a dead heat so far in November. Howard Silverblatt, senior index analyst for S&P thinks, “We have turned the corner on dividend stocks”. One of the reasons for this might be more people thinking like Ronen Feldman, a 46-year old engineer from Ellicott City, MD who said, “I want safer stuff”.
Vito J. Racanelli profiled 10 stocks in Barron’s this week for their dividend paying ability including: Banco Santander (STD), Chevron (CVX), Intel (INTC), Johnson & Johnson (JNJ), McDonald’s (MCD), Nestle ADR (NSRGY), Novartis ADR (NVS), PepsiCo (PEP), Proctor & Gamble (PG) and Verizon (VZ).
I recognized some these names immediately from the CEC universe and thought that given the stated outperformance of the dividend paying stocks over the last two months I would find declining CDS spreads and rising stock prices in each case but as the Gershwin brothers put it so eloquently that; “Ain’t necessarily so.”
What I found most interesting when looking at the CDS/equity combo’s for these names was that for six out of the ten names (STD, JNJ, MCD, NVS, PEP, VZ) both the CDS and equity were rising in tandem.
Since the relationship between CDS and equity has been empirically proven to be negatively correlated having both the CDS and equity price rise simultaneously raises two red flags. The first being that the negative correlation has broken down and second that the credit markets see the environment for the company worsening as opposed to improving.
Investment grade CDS spreads, as represented by the CDX index, have bounced between 110bps and 91bps since early September and while movement since the 91bps low on 9/22 and the 110bps seen on 10/1 have contained all of the price action since, the subsequent lows have been higher (95bps on 10/14 and 98bps on 11/9) while the highs (109bps on 10/28 and 10/30) seem stalled.
Given the economic reasoning behind CDS spread movement it is unlikely that a positive correlation between spreads and equity prices will remain for long. What is yet undecided is whether, after the corporate debt buying binge that went on for much of the year, spreads are widening some to reflect sated demand or whether CDS spreads are detecting movement in the back wall of the hurricane.
Enjoy the week.
Jim Delaney
