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.
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.
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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