"The credit market is showing significantly more fear than the equity market. There's a gaping hole between them," says Tim Backshall, chief strategist of Credit Derivatives Research in Walnut Creek, Calif. In ordinary times, stock and bond investors see pretty much eye-to-eye when sizing up the risk of corporate default. When bond investors get nervous about a default, the stock price gets whacked because shareholders are the first to be wiped out in a bankruptcy. Lately, though, bond and derivative investors have been far more pessimistic than their equity brethren. If they're right, stocks could be in for big trouble. One of the most sensitive gauges of risk is the credit default swap market, and it's flashing red. The swaps are contracts on the possibility of a corporate default. One party buys protection from default for an annual fee, while the counterparty that collects the fee commits to paying in case of a default. If the cost of protection goes up, it means the shares are in some danger, even if the stock price doesn't show it.
A recent example of the swaps market's prescience is the case of insurers American International Group and MBIA . Swaps turned skittish about their prospects long before the stock market caught on to the companies' problems. The cost of default protection on MBIA bonds soared last summer and fall at a time when "the story from the equity market was that MBIA was going to benefit from the turbulence in the credit market by insuring more bonds," says Gary Kelly, head of research in the New York office of Tradition, a Swiss-owned broker for big dealers.