Here is updated chart (on May 16) and some wording from ContraryInvestor
idorfman.com
Tight And Right?...At least for ourselves, this is probably one of the most important questions of the moment. In terms of equities, the ultimate correct answer to this question either very much validates current price momentum or gives us reason to call the current rally another flight of hopefully fancy in what is otherwise a powerful bear episode. For bond holders, the correct answer will clearly shed a bit of light on the potential for interest rate risk over the intermediate term. As you know, yield spreads are tightening throughout the broad fixed income markets at the moment. By yield spread tightening, we are referring to the yield relationship, or differential, between various classes of corporate, high yield, emerging market, etc. debt instruments and theoretically safe and sound US Treasuries. Historically, yield differentials between US Treasury securities and other forms of fixed income instruments have widened during periods of heightened economic and financial risk. It's only a natural as corporate earnings and cash flows come under pressure during periods of economic instability or stress. Likewise, yield spread differentials during tough economic periods also widen because there is often an accompanying flight to the perceived quality and cash flow safety of US Treasuries (naturally bidding UST prices up and yields down). Simple supply and demand dynamics driven by the perception of risk drive yield spread widening and contraction.
Over the past few years, the fixed income markets have witnessed some very wide yield spreads between Treasury securities and those found in main line corporate and high yield debt markets. In fact, these spreads could be described as extreme. As you can see below, late last year witnessed a peak in the yield spread between Moody's BAA rated corporate debt and the simple yield on the 10 year Treasury. A yield spread not seen since the early 1980's:
What is certainly important and plainly obvious in the above chart is that yield spreads hit an extreme and have now started to contract. Although it may not seem like much spread tightening against the magnitude of the history that you see above, the contraction in the spread between Moody's BAA paper and 10 year Treasury yields has been 75+ basis points since late last year. In a world characterized by forty year lows in Treasury yields, this spread contraction is far from inconsequential on an absolute basis. History teaches us that when yield spreads in the bond markets hit an extreme and begin to contract, the broader financial markets are generally anticipating an improved economic environment ahead. Sentiment begins to change as investors become willing to move further out on the financial risk curve with their investing activities.
Over the last six to seven months, it's important to note that yield spreads between what is considered risky debt and safe US Treasuries has continued to contract during a period where US Treasury yields have also continued to decline to levels seen maybe once in a generation. For now, we believe possibly the most important question for the total financial markets is whether this yield spread contraction being seen in the broad fixed income arena truly signifies a better economic environment ahead, as historical experience might suggest, or whether investors shocked by the low absolute level of yields available in safe fixed income investments are simply "chasing yield" in higher risk securities without fully pricing in the credit risk being undertaken in the purchase of corporate, high yield, emerging market debt, etc.? For now, the jury is out on whether "tight is right", but we believe the ultimate answer will shape the face of the broad financial markets over the intermediate term.
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