The Bad-News Bonds

Who are the big losers if the credit markets collapse? You and me.
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"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

Even though the headlines have focused on the travails of S&P 500 members such as


(F) - Get Report


General Motors

(GM) - Get Report



(AIG) - Get Report


Fannie Mae




(IBM) - Get Report

, the S&P 600 fell the most once credit quality began to deteriorate in March. The small firms have less access to financing than their larger cousins do, and therefore they will be more vulnerable if the credit markets lock, as they are wont to do in a crisis. Life is not fair, is it?

Linking Stocks and Bonds

Financial postmortems usually discover one of three causes. The first is the assumption of continuous and liquid markets; in reality, liquidity is the only asset whose supply disappears when its price is raised. The second is the assumption that past correlations will remain constant during a crisis; in reality, correlations move to 1.00 in a crisis as panicked traders sell risk and buy safety. The third is what option traders refer to as being short gamma: Any insurance writer is short gamma, while the insurance buyer is long gamma. Who writes the checks after the disaster, and who cashes them?

CDS writers are guilty of all three in some sort of you-have-got-to-be-kidding trifecta. They are short put options on corporate bonds and call options on the stock. They are assuming the stock-bond relationships will remain predictable as a crisis unfolds. And they are assuming they can trade their way out of the situation on the really amusing assumption that someone else will care about their plight.

And to top things off, they have the same risk profile that was present in 1998 during the Long Term Capital Management debacle: They are long on risk and short the safety of the Treasury curve. If the

Federal Reserve

backs away from its measured pace of rate hikes, as speculation last Friday had it, this last problem will be worsened, as Treasury yields will fall more rapidly than corporate bond yields will. In terms of the risks posed to the financial system, these traders are suicide bombers in pinstripes, if I may date myself with the choice of preferred wardrobe.

If past is prologue, and it usually is, who will be on the hook for any accident? You and me: The CDS writers are the usual too-big-to-fail suspects. If General Motors declares bankruptcy, you and I will own their pension liabilities through the Pension Benefit Guaranty Corporation. If J.P. Morgan gets on the losing end of CDS obligations, we will own those. And we already own the unfunded liabilities of Medicare and Social Security.

We own, we own, we own. That's why we are the ownership society, is it not?

Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of

The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to has a revenue-sharing relationship with under which it receives a portion of the revenue from Amazon purchases by customers directed there from