Why the Market Rally Didn't Affect Bond ETFs

As Treasury Secretary Timothy Geithner’s plan to rescue the financial system sent the market and ETFs soaring, the bond market hardly flinched. Why?

Corporate debt is still priced for a disaster and investment-grade non-financial U.S. corporate bonds rallied in January but now have stalled, with spreads about four percentage points above Treasuries. To top it all off, U.S. senior bank-bond spreads remain at their widest levels since the demise of Lehman Brothers.

Bonds are pricing in unheard-of and devastating levels of default. According to Deutsche Bank, investment-grade corporate bonds were pricing in a five-year default rate of 40%, assuming average recovery rates. Additionally, even if one makes the assumption that bondholders recover nothing after default, prices suggest a 25% default rate over five years. The worst five-year investment grade default rate since 1970 is just 2.4%, states Richard Barley of The Wall Street Journal.

On the aforementioned basis, corporate debt is ridiculously cheap and the credit markets are being held back because of the lack of demand for financial debt. The demand in the credit markets is being gobbled up by nonfinancial debt. This is a good indicator that all is still not well with the banking industry.

Until investors recover confidence in financial assets, credit spreads are unlikely to tighten. Some ETFs to watch when considering bonds are the following:

• iShares iBoxx $ Investment Grade Corporate Bond (LQD): down 8.4% year to date; down 1.7% in the last week; yield of 5.82%

• Vanguard Total Bond Market (BND): down 2.8% year to date; down 0.7% in the last week;yield of 4.64%

Kevin Grewal contributed to this article.