What Was Important About Mr. Greenspan’s Testimony
Over the past few weeks,
I have dedicated a fair amount of my focus to discussing how
corporate bond (including junk) yields have narrowed relative to those of
Treasuries and how this can be interpreted as a positive sign for equity
investors–since there is a strong historical correlation between the two. My
focus here has been on the similar risk profile between these two instruments,
and how, ultimately, if one benefits so should the other. The reason behind this
argument is that investors in both instruments look at the general state of
corporate health. Today, however, I would like to expand this discussion to
include a simple economics perspective of this relationship, as this topic has
been recently mentioned by several important individuals in the financial
community.
Yesterday, in his testimony before the House of
Representatives, Mr. Greenspan noted, “The recent improvements in financial
markets, if maintained, would seem to suggest a turnaround in capital spending
(business spending). In this regard, the ongoing decline in risk spreads in
corporate bond markets so far this year is an encouraging development.”
What Is The Chairman Talking
About?
The spread between corporate bonds and Treasuries
is now at multi year-lows (lowest since 2000) and has narrowed by more
than 400 basis points in the past year to 680 basis points. And this event
should help the economy in the months ahead for two reasons:
First, it allows companies to finance new
equipment expenditures at much cheaper levels–since investors are willing to
pay more to purchase new company bonds. Essentially, this makes the real cost of
new equipment cheaper, which should encourage companies to replace and upgrade
all of their currently aging tech equipment at cheaper levels.
Second, lower corporate bond rates allow companies to refinance their existing
debt at much cheaper levels. This, in turn, lowers a corporation’s debt payment,
which then frees up its cash for investment.
In fact, the current ratio of cash to capital investment (business spending) is
at levels that, on a historical basis, would suggest an increase in spending.