Credit Thaw Update: Banks More Confident in Lending to Their Peers

In a sign of improving confidence about banks and businesses in general, interest rates have been dropping in the credit markets both in the U.S. and Europe. Banks are showing greater confidence in lending to one another for short periods, and investors in both investment grade and high-yield corporate bonds are accepting lower yields, indicating less fear about corporate failure.

In the Libor (for London inter-bank offered rate) market, three-month sterling rates dropped for the 44th day in a row, to about 1.5 percent, while U.S. dollar rates were down for the 22nd day to just over one percent, according to the Financial Times. (On April 1, rates were about 0.2 percent higher.)

Banks frequently borrow money from each other to meet short-term needs, and high Libor rates were a sign that banks were reluctant to lend even for short periods. Libor rates are also often an index for the cost of mortgages and business loans, so lower rates and greater availability of funds generally translates to easier credit for the rest of the market. For loans of six months and longer, however, there is little interbank lending, suggesting banks are still nervous about each others' risk profiles.

Yields on corporate bonds have fallen as well, illustrated in this graph from the St. Louis Fed. Bonds rated Baa (investment grade) by Moody's yielded 8.25 percent April 27, versus 8.38 percent on April 1, and a high water mark of 9.54 percent on October 15, during the colossal uncertainty after the failure of Lehman Brothers. Corporations responded by raising a record amount of debt during the first quarter of 2009.

The high-yield bond market (consisting of companies with credit ratings below investment grade -- also known as "junk") has improved as well Yield on the Merrill Lynch High Yield Master II index was 16.6 percent yesterday, down from 18.7 percent April 1, and 19.5 percent at the start of the year.

In a more normal bond market environment, investment grade bonds would normally be priced to yield perhaps one percent more than 10 year US Treasury bonds, while high-yield bonds might be five percent over. So even though corporate bond rates have fallen, they're still a long way from their typical relationship to government bonds, indicating plenty of investor uncertainty over companies' ability to pay interest and principal.