Changes in Corporate Bonds, Part 2

This column was originally published on RealMoney. It's being republished as a bonus for TheStreet.com readers.

Two changes have taken place in the corporate bond market in recent years. The first change deals with credit default swaps (or CDS), which I discussed in Part 1. Today, in Part 2, I'll examine how corporate bonds are analyzed differently now.

Since the bottom of corporate bond market in the 2002, corporations have enjoyed stronger profits and free cash flow. Many corporations have deleveraged. This would be reason alone for corporate spreads to tighten. But there is another factor at play here that is less known outside of the corporate market.

Two Methods of Analysis

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 primarily uses market-oriented variables like 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.

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David J. Merkel, CFA, FSA, is 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. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.