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Morgan Stanley Issues Alert On Corporate Bonds After Explosive Rally

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Andrew Sheets, the bank's European credit strategist, has advised clients to beware signs of creeping angst in the credit options markets, where volatility has been flashing an early warning signal for some weeks.

"The pace of the recent rally has, for the first time, begun to show signs of over-extension," he said.

The September option contracts have seen a "sustained rise in implied volatility" yet the interest spreads on corporate bonds have continued to drop sharply. Bond investors ignore this sort of divergence at their peril.

Morgan Stanley said none of the previous bond recoveries going back to 1925 had been as dramatic as this.

"Credit rallies are historically fast and fierce, but this one has become unusually rapid. Levels are almost back to where they were in the first quarter of 2008, but equities are still a long way off that," said Mr Sheets.

Analysts say the current dividend yield on the German utility RWE is 7.7pc while the interest return on a five-year bond issued by RWE is 3.2pc, and the credit default swaps have dropped to just 50 basis points.

These markets are clearly out of alignment. They appear to be reflecting an assumption of a prolonged 'bond-friendly' form of gentle deflation, which is at odds with assumptions in the rest of the market.

The credit euphoria undoubtedly reflects the emergency measures by governments around the world to stabilize the financial system, but the wash of liquidity should be an equally good tonic for stock markets. Credit rallies usually anticipate stocks by about 3 months, but we are well past that stage of the cycle. The two should be converging by now.

Either stock markets will have to rise sharply to close the gap - an outcome in doubt after poor confidence date in the US and jitters in the Shanghai markets as the Chinese authorities restrain lending - or credit spreads must start to widen again to reflect the risk.

Spreads on non-financial grade BBB-rate bonds in Europe have dropped backed to the long-term average of around 200 basis points above benchmark government bonds, a fall from over 548 earlier this year. This may prove "rich" given the spate of defaults expected by the rating agencies over the next two years.

It has taken just eight months for spreads to recover fully in this rally. It typically takes almost three years, and sometimes much longer. The credit markets seem to be telling us that the Great Recession of 2008-2009 was much ado about nothing.

It's the new paradigm of debt is wealth.

This was not understood before.

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It's the new paradigm of debt is wealth.

This was not understood before.

It's much more difficult for intermediaries to make money in illiquid and tight markets. They forgot to mention people just happy sitting on their assets and doing nothing in an environment like this. In some ways, it does resemble the sanguine summers of 2007 and 2008 before credit markets imploded and NR went bust in 2007 and Lehman last year. Wondering if we are going to have a convulsion of that kind this year, a small black swan?

Edited by Meerkat

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So equities yield more than bonds?

Big deal. Equities carry higher risk.

And I'm not talking about the risk of a company going bust (equities wiped out, bondholders get whatever the administrators can raise). This is about companies which remain solvent but tighten the belt. The easiest payment to cut is the dividend, whereas bondholders come above not just shareholders but also staff costs in the pecking order.

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