The Bad-News Bonds

"The rich are different from you and I."
"Yes, they have more money."

-- Purported exchange between F. Scott Fitzgerald and Ernest Hemingway

The differences between stocks and bonds have fascinated analysts for years. Standard-issue corporate bonds differ in their seniority in corporate capital structure, their finite maturity vs. stocks' perpetuity, their finite reward structure vs. a stock's growth potential, and their lack of ownership rights prior to bankruptcy.

A secondary debate has raged for years about which market is "smarter," a metric that should be used with extreme caution in the realm of finance. For what it is worth, I addressed this topic in a pair of articles in May 2003. The first set up the test of causation between the two markets, and the second proffered the conclusion that stocks were slightly ahead of bonds in their ability to look forward.

In practice, I describe the relationship as asymmetric. A stock can get slammed on some end-of-the-world tragedy such as missing its earnings estimate by a penny per share, but the bond can sail past this awful news, confident that the credit quality of the company is safe. The opposite seldom is true: If a corporation's bonds falter -- and please note how I said "falter" rather than "get downgraded," the latter condition arising only after the fact -- the stock should be in trouble as well. After all, stocks represent a claim on earnings after interest payments.

We should note in passing that there are situations such as leveraged buyouts in which bondholders get clobbered while shareholders prosper.

Credit Default Market

The columns referenced above looked at the yield spread between corporate bond indices and comparable Treasuries. The market for credit default swaps (CDS), an insurance contract on a specific issuer's default risk, has exploded in recent years. The narrow corporate bond spreads seen since 2003 have reflected the combination of investors buying corporate bonds and CDS. Investors are willing to accept lower bond yields if they believe their default risks have been insured by a creditworthy counterparty.

If we view the above transaction in option terms, the combination of a corporate bond plus a CDS -- which acts as a put option -- is a synthetic call option on the bond. In a perfect world, anyone writing the CDS protection should hedge their risk by selling a quantity of the bonds themselves, but this is a difficult transaction to execute, given the relatively small quantities of bonds available and the costs involved in shorting those bonds, such as making the coupon payments. CDS writers instead have taken to hedging their risk by selling the underlying stocks and options on those stocks as a hedge.

The selling of stock options, calls in particular, has been one reason why the CBOE's Volatility Index (VIX) has been drifting lower for two years. The CDS hedgers should buy the put options in addition to selling the call options, but let's face it: Most investors would rather undergo a root canal without Novocain than pay for put-option premium. The relationship between the declining cost of CDS insurance on a Morgan Stanley index of five-year bonds and the VIX and Nasdaq Volatility Index (VXN) is quite visible. The CDS index has been rising steadily since early March, while the stock volatility indices moved higher only when stocks started to break for good in April.

Parallel Risk Dimensions

Source: Bloomberg

We can restate the above relationship in terms of index price. If we depict the CDS cost on an inverse scale and compare it with the indexed price levels of the large-cap S&P 500, the mid-cap S&P 400 and the small-cap S&P 600, we can see how declining CDS costs led the stock rally in 2003. As time moved on and CDS costs bottomed near 20 basis points, or 0.2% of the bonds' face value, the smaller stock indices rose further and faster than the larger ones.

Size Matters: S&P Index Sensitivity to Credit Default Risk

Source: Bloomberg