Two Methods/Rules for Analyzing Corporate Debt

This was written on July 16, 2004. I republish it now because it cannot be found on RealMoney’s website. If you subscribe to RealMoney, demand that you can see my old posts.

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Tighter corporate spreads imply stronger profits and free cash flow at debt-issuing corporations. But there is another factor at play here that is less known outside of the corporate market.

There are two distinctly different ways to analyze corporate bonds. The first way is the old standard, which relies on fundamental analysis of a company’s financial statements. The second way relies on contingent claims theory (options theory, Merton’s model) and relies primarily on market-oriented variables, such as stock prices and option volatility.

The basic idea behind the latter method is that the unsecured debt of a firm can be viewed as having sold a put option to the equity owners. In an insolvency, the most the equity owners can lose is their investment. The unsecured bondholders (in a simple two asset class capital structure) are the new “de facto” equity holders of the firm. That equity interest is most often worth far less than the original debt. Recoveries are usually 40% or so of the original principal.

Under contingent claims theory, spreads should narrow when equity prices rise, and when implied volatility of equity options falls. Both of these make the implied put option of the equity holders less valuable. Equity holders do not want to give the bondholders a firm that is worth more, or more stable.

So what’s the point? Over the last seven years, more and more managers of corporate credit risk use contingent claims models. Some use them exclusively, others use them in tandem with traditional models. They have a big enough influence on the corporate bond market that they often drive the level of spreads. Because of this, the decline in implied volatility for the indices and individual companies has been a major factor in the spread compression that has gone on. I would say that the decline in implied volatility, and deleveraging, has had a larger impact than improving profitability on spreads.

 

By David Merkel, CFA of Aleph Blog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.