Eye on the Market I May 23, 2011 J.P.Morgan Feast or Famine: an update on public and private credit markets; Why Greece o Uruguay; Fannie/Freddie post-script Credit markets are schizophrenic things. Instead of holding to an equilibrium that works for both issuers and investors, credit markets often veer back and forth between investor-friendly (after recessions) and issuer-friendly (after yield-chasing by investors). The Fed played a large role this time, as zero interest rates render cash temporarily useless as a store of value, driving even more flows into credit. After the shock in 2008, there was a surge of inflows into high grade and high yield bond funds. High grade spreads are almost back to where they were in the spring of 2007, while high yield spreads are still modestly wider. Last week saw the most high yield issuance on record, as issuers recognize the opportunity. High grade and high yield mutual fund flows High grade and high yield spreads, 1987-2011 3 month rolling average, USD billions Basis points 1A 5 2.000 1.2 Inflows 1.800600 1.0 High Yield (LHS) 4 1. 0.8 High Grade (RHS) 3 1.400 0.6 0.4 2 1.200 High Yield(LHS) 1.000 0.2 1 800 0.0 -0.2 I 0 600 -0.4 1 400 -0.6 Outflows 200 -0.8 -2 0 0 2000 2002 2004 2006 2008 2010 1987 1991 1995 1999 2003 2007 Sou ce:AMG Data Services. Source: M. Morgan Securities LLC. Ibbotson Corporate cash flows and cash balances are at elevated levels, and high yield default rates have plummeted, so we would not characterize credit spreads as being wildly expensive. But there's a risk that the credit markets are ahead of themselves, particularly with risk-free rates near all-time lows. It's not a credit spread famine yet for investors; more like an overpriced restaurant with mediocre food (people will gradually start eating elsewhere). U.S. High Yield default rates Percentof par value 16% Famine Feast Feast p Hi h Grade RHS 2011 U.S. HY bonds and loans t