Monday 17 January 2011

A tale of two markets - Credit versus Equities

At the start of the Financial crisis, with the subprime debacle of the summer of 2007, there was a big disconnect between the credit markets and the equities markets. Volatility was falling on the equities market meanwhile credit spreads were simply exploding, sometimes with gigantic intraday movements. I remember seeing 100 bps intraday move on the 5 year Itraxx Crossover index.

Credit markets, were early indicators of trouble in 2000 and 2007.

Tracking the implied volatility skew from equity options can be a good indicator of market movements in the equity world. Skew indicates the difference in demand for put options and call options. Following the standard measure of three-month volatility skew can be very useful.

In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.

In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money)equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study.

The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates. In a recent post, we touched on the subject in relation to the wall of maturities facing financial institutions up until December 2012 competing at the same time with Sovereigns in the need as well and the risk of crowding out.

Both credit and equity markets (as well as equity volatility) are driven by macroeconomic news.

There is a belief that fixed income markets are "smarter" than equity markets. It was certainly the case in 2007.

Today we have again an interesting disconnect:

In the graph you have:
Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year government bond, GDBR10), and at the bottom Eurostoxx 6 months Implied volatility.

At the same time, European High Yield debt is tighter than Bank Sub debt.

Europe's Junk Proves Safer Than Risky Bank Debt:

"The extra yield buyers demand to own high-yield non- financial notes instead of government securities fell below that on bank subordinated debt on Jan. 6, and is now 29 basis points lower, according to Bank of America Merrill Lynch index data. Before November, speculative-grade bond spreads had never been within 100 basis points of those on bank notes, which on average are rated eight steps higher."

"Relative yields on speculative-grade European company debt shrank 51 basis points to a three-year low of 437 since Oct. 31, a month before Ireland asked for an 85 billion-euro bailout, according to Bank of America Merrill Lynch’s Euro Non-Financial High-Yield Constrained Index. Subordinated bank bond spreads widened 125 basis points in the same period to 466, approaching the highest since July, the EMU Financial Corporate Index, Sub- Type shows."

"Financial credit has “significantly decoupled” from the rest of the corporate bond market since November because of higher expected losses and increased volatility amid the sovereign crisis, Morgan Stanley strategists led by Andrew Sheets said in a Jan. 14 report."

This leads us to discuss Capital Structure Arbitrage.

Capital Structure Arbitrage is according to the definition: any of a number of trading strategies designed to arbitrage the relationship between assets issued at different parts of a company's capital structure. Examples include convertible arbitrage (trading convertibles against equity options, for example), trading secured loans versus unsecured bonds of the same issuer and trading senior debt against subordinated debt of the same issuer.

It will be a big theme in 2011 according to UK Special Situations manager Alex Breese:

He said: "The capital structure arbitrage currently presented by corporate bonds yielding less than the free cash flow yield on equity will encourage the quoted sector to buy equity, either through share buybacks or merger and acquisition activity."

"This will be one of the key drivers for the UK market in 2011."

And probably a key driver in the credit space in general.

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