Changes in Corporate Bonds, Part 2

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 happened. I would say that the decline in implied volatility, and deleveraging, has had a larger impact on spreads than improved profitability has.

Wider Implications for the Markets

Contingent claims models are not perfect, but they are quite good. To ignore them is foolish, but understanding their weaknesses is helpful.

Contingent claims models have a tendency to overestimate the risk of default with corporations that are overleveraged but have a long maturity debt structure. In many of these cases, the indebted corporation has a great deal of "breathing room" and often can maneuver its way out of the situation. This can offer real opportunities for buy-and-hold investors because they can buy the debt or equity at depressed levels and hold it through the apparent crisis. Doing this requires careful fundamental analysis, so if you invest in any of these situations, make sure you do your homework thoroughly.

Finally, the combination of contingent claims theory and the existence of CDS can produce other anomalies. It becomes theoretically possible to hedge CDS against common equity. Some hedge funds do this. They analyze bank debt, corporate bonds, convertible bonds, preferred and common stocks, options, warrants and other financing instruments, to find the cheapest aspect of a company's credit structure and buy it, and find the richest aspect and sell it.

The full set of implications for the asset markets from this is unknown, partly because funds that do this are small relative to the markets as a whole. If the hedge funds that did this were too large for the markets, it would create too many feedback loops that have not yet been tested, which would have a tendency to amplify price moves in a crisis.

I can't tell where such a crisis might lurk. The markets are relatively optimistic now. But being aware that these feedback loops could exist, can give you an edge in a crisis. The main upshot is this: Having a strong balance sheet is worth more today than it was in the past. It's one of many reasons why I continue to focus on higher-quality companies in my equity investing.

>To order reprints of this article, click here: Reprints