In the fall of 2007, before the economy began to falter, corporate-bond prices were signaling all was not well. The spread between corporate-bond yields and Treasury yields, which had begun to widen amid that summer's mortgage woes, showed little improvement even as the Dow Jones Industrial Average clocked record highs.
It wasn't the first time bonds had signaled something was awry. One of the head scratchers of early 2000 was why stocks were surging when high-yield bonds were wavering. In retrospect, the bonds had it right.
Bond investors are intensely focused on companies' ability to pay down debt. If they see signs business is slowing, they demand higher returns, and thus higher bond yields. Widening corporate-bond spreads can also reflect disruptions in the credit supply -- say, because banks are mired in bad mortgages -- that eventually sap the whole economy. Finally, widening spreads can induce companies to cut back on expansion plans, which also has economic consequences.
Bonds' forecasts haven't always seemed to come true. Many corporate-bond indexes showed spreads widening significantly during the 1998 Russian debt crisis, and yet the economy soldiered on.
Such false signals mightn't be because of corporate bonds themselves, however, but the way corporate-bond indexes are constructed. The bonds in them tend to have much shorter times before they will mature than the 10-year Treasurys that their yields are usually compared with -- which makes for a faulty comparison.
Consider the following charts:
