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The credit markets recently passed an important milestone when the spread between the BAA corporate bond index and the 10-year Treasury bond fell below 250 basis points. This spread is a good measure of the willingness of lenders to take on default risk.

In the best of times, the spread is around 160 basis points, and that’s where it was during the summer of 2007. By early 2008, the spread doubled and then nearly doubled again during the frantic days of September 2008. The spread reaches its peak of 616 basis points on December 4, 2008.

Since then, the spread has plunged. It dropped below 300 over the summer, and it just recently fell below 250 for the first time in over two years.

So what does that means for equities? It’s hard to put an exact effect on each instance, but historically stocks have shown a clear preference for a tighter BAA-10YTB spread.

I ran the numbers and found that since 1986, when the spread is 250 basis points or more, the stock market has lost an average of -4.50% annually. When the spread is 249 basis points or less, the market has gained an average of 12.13% annually.

There’s probably a feedback loop at work. Because the yield spread narrows, it’s good for companies because it lowers their borrowing costs. The lower borrowing costs make them more profitably and in turn, less likely to default.

Posted by edelfenbein at January 13, 2010 10:57 AM