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By Jeremy Glaser and Dave Sekera, CFA | 09-17-2013 10:00 AM

When the Bond Market Was Broken

Morningstar's Dave Sekera describes the market breakdown after Lehman, the state of the bond market now, and investors' heightened attention to systemic risk today.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. How did the corporate credit market react to Lehman Brothers' bankruptcy, and has it recovered since? I'm here with Dave Sekera. He's a corporate bond strategist at Morningstar. We're going to take a look at these questions.

Dave, thanks for joining me.

Dave Sekera: Good to be here.

Glaser: Let's take a look at what happened in the bond market immediately during and then the aftermath of the Lehman bankruptcy. How is it different from just kind of a run-of-the-mill recession and what you would expect to see in any kind of economic slowdown?

Sekera: It's definitely its own crisis that was caused by the Lehman bankruptcy. And if you look at the corporate bond market, corporate credit spreads did start widening out as we were looking at going into recession at that point in time. Housing was definitely starting to soften.

But unfortunately, unlike a normal recession, where credit spreads widen out because you do have the market pricing in a higher probability of default, really when you are looking in a normal recession like in 2000, 2001, even in 2002, when you did have individual companies that filed for bankruptcy. You had Enron. You had MCI Worldcom, which were caused by accounting scandals. But you really didn't have the fear of systemic risk. When those companies filed for bankruptcy, you weren't necessarily as worried about a big domino effect that as soon as one of those companies went bankrupt, that all of a sudden, all these other companies were going to fall off the chain, as well, filing bankruptcy.

Really once Lehman Brothers filed bankruptcy, it really caused the panic among financial institutions who were worried about lending money out in the short term to other financial institutions. And so as they then pulled in their own liquidity, it caused liquidity problems at a lot of other financial companies.

The banks were looking at each other. No one really knew who owned what on their balance sheets or what those assets were worth, and so everybody was worried about what was called jump-to-default risk at that point in time.

Glaser: Put some numbers around this. What would a typical credit-spread increase look like for a recession, such as in 2000, versus right after Lehman?

Sekera: In 2000-01, it probably backed off 75 to 100 basis points, and then we had another blip up in credit spreads at the end of 2002. I think credit at that point in time had widened out and got to its widest levels in October. Probably from the tightest levels to the widest levels [during that time], spreads were 150-175 basis points.

And that's where we're probably were looking at in 2007 from the spreads as tight as they were then, going into the middle of 2008. But then at the Lehman bankruptcy, when that hit, spreads gapped out so far and so fast that they're almost meaningless at that point in time. The Morningstar Corporate Bond Index, I believe, touched 600 over, but effectively, the bond market at that point in time was broken.

Having traded bonds during that point in time, there were no markets that the dealers were making. The dealers were putting out what they thought were indications of where bonds would trade, but if you actually went and tried to hit them with bonds that you were trying to sell, they wouldn't take it on their own balance sheet. They are happy to work an order for you, but the bond market itself was really freezing up.

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