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Widening credit spreads bad news for Canadian bank stocks

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Canadian banks are remarkably sensitive to changes in U.S credit conditions. This used to be a good thing; now, not so much.

Corporate bond spreads are the most widely-used gauge of credit conditions. Spread is a term used to describe the difference between any yield-bearing investment and a government bond, usually ten-year U.S. Treasuries. The spread between U.S corporate bond yields (measured by the Merrill Lynch U.S. Corporate Master benchmark in our case) and the ten-year is the usual proxy for spreads as a whole.

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This chart shows that the S&P/TSX Bank Index and U.S credit spreads have been moving in exactly the opposite direction; the correlation is –0.89 using daily data from January 1, 2012. (Comparisons with Canadian corporate rates are difficult because the Canadian high-yield market has nothing near the industry sector diversification of depth of the U.S.) When spreads fall – as has generally been the case over the past twelve months – bank shares rise.

Narrowing spreads imply two good things for bank stocks. One, tighter spreads indicate lower corporate bond rates. This increases lending – companies can afford to borrow more in the same way as lower mortgage rates help homebuyers.

Two, tighter spreads relative to government bonds indicate increased trust in corporate balance sheets. The market demands less return (in the form of corporate bond yields) to offset the risk of default. By extension, this also increases faith in bank balance sheets.

The damage to credit spreads – higher by 17 basis points on average since May 22 – is not yet severe. Higher spreads have, however, helped push the domestic bank index down four per cent for the same period.

Investors concerned about yield-sensitive investments like bonds, REITs and utilities should also watch bank stocks closely. Changes in interest rates and credit spreads can have just as big effect on them.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .

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