Improved liquidity conditions underpin credit markets (Sep 09)

Corporate bond spreads have ground even tighter over the past month. Aside from the improvement in the incoming economic data, which has reduced required compensation for the risk of default, the ongoing rally has been aided by better liquidity. This can be seen by looking at the difference between the asset swap spread of corporate bonds and the credit default swap (CDS) premiums attached to the same borrowers over the same time horizon. Both should reflect the underlying credit risk of the borrower and in normal times should be similar. During the credit crunch, CDS premiums rose by much less than asset swap spreads, primarily because of soaring funding costs. But the gap has since shrunk substantially, in part thanks to quantitative easing.