Thursday, 21 February 2008

Equity/Credit: Who's Right?

Naked Capitalism has a thought provoking article on the current disconnection between the equity markets and the credit markets, which in turn refers to FT articles by John Authers and John Dizard. Authers describes the issue:
If you believe the credit market, things have worsened sharply in the past few weeks. With spreads widening significantly, recession is a certainty in the US and Europe.

If you believe the equity market, there are grounds for optimism. Stocks are still above the low they hit in January, before the Federal Reserve made its emergency rate cut – betting that this huge monetary stimulus would ensure that any recession is shallow.


But in the past few weeks, as credit spreads have widened, the shares of those companies the credit market sees as most risky have rallied, and outperformed the rest of the market. Equity investors are making a bet that the credit market has got it wrong.

The credit market may be at levels that cannot be justified by the fundamental outlook for defaults: its investors have difficulty raising liquidity; many need to clean their balance sheets; there are unprecedented worries over various structured credit products, many of which did not exist during the last downturn in the credit cycle; and the problems of the monoline bond insurers create further uncertainty.
One has to sympathise with this last: we are in a situation at the moment where most of many instruments credit spread is compensation for factors other than default, prominent amongst them the cost of financing the position, the possible future volatility of the position, and the liquidity risk of the position.

This leaves some serious issues with equity/credit (aka capital structure arbitrage) models though. The vast majority of these models are based on the assumption that the credit spread is (risk neutral) compensation for the probability of default, and that equity is (some kind of) option on the value of a company struck at the face value of the liabilities. Given these assumptions and a few more besides, a connection between equity prices and credit spreads is established. But if there is a systematic component to credit spreads which varies strongly with time then most of these models are some trouble. And certainly their predictions earlier in the year wouldn't have ensured career success. As Dizard puts it:
Let's say you decided at the beginning of the year, with what was left of your limited partners' capital, to bet that the price of risk in both markets will converge. So, you go short a basket of stocks of investment grade companies, and simultaneously buy the CDX.IG, the index of investment grade credits. However, since, historically, stocks in the form of the S&P 500 are seven times as volatile as the CDX.IG, you levered up the CDX at the multiple required to have a hedged position. Unfortunately for you, in the first week of February, the CDX moved (down) one fourth, not one seventh, as much as equity, as dealers stopped providing liquidity. So your position just died and went to money heaven.
Leaving aside Dizard's hedge ratio calculation - which is far too naive - he is basically right. And remember you need models like these for a range of wacky convertibles, too, so this is not just a matter of interest to the CSA funds. If nothing else this little market episode will result in some improvements to equity/credit models.

Update. There is further comment from the FT, based on a report by Goldman, here. Some of the examples given here are fascinating:
In the first three weeks of February, the shares of Swedish truckmaker Scania rose 11 per cent. But the spread on its credit default swaps (CDSs) rose 60 per cent... Over the period, spreads on the 155 names in the iTraxx main index of European investment-grade companies widened 55 per cent on average. The figure for 103 names not on the index – including, for instance, Scania – was 41 per cent.
I am not brave enough to opine for certain which market is right. But it is clear that one of them is wrong. And if it is the equity market, there is a lot more pain to come.

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