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

Two changes have taken place in the corporate bond market in recent years. The first change deals with credit default swaps, which I'll discuss in today's column. In Part 2 I'll talk about how corporate bonds are analyzed differently now.

Surviving the Loss of a Major Class of Investor

There used to be a tendency for Wall Street to hold a supply of corporate bonds to sell to the buy side. That changed when credit default swaps were, or CDS, developed. A credit default swap is a transaction where one party buys protection against the default of a corporate credit from another party. The party selling protection receives a constant payment over the life of the transaction so long as the corporate credit does not default.

These swaps were developed in the mid-1990s, but they remained somewhat tangential to investment banks until the negative side of the credit cycle hit in 2000-2002. Many banks did a huge business in CDS, but they traded cash bonds and CDS separately. Typically, the cash bond side of the house was net long corporate bonds, and the CDS side was typically flat credit risk. From late 2001 through 2002, a major change rippled through the "bulge bracket" firms on Wall Street. They got the bright idea to trade cash bonds and CDS together as a group. This had several desirable outcomes:

  • It enabled them to hold a larger inventory of corporate bonds with less risk.
  • It enabled them to be flat the corporate bond market in a period of severe stress. (However, it must be noted that most of those that instituted programs like this had the trough of the corporate bond market.)
  • It allowed them to trade more rationally. There were new trades that could be done by comparing the cash bond market and CDS market, going long one and short the other. (Note: Here's how to make money on corporate trading desks: You have more flow in the market than most people you trade with. When clients offer you mispriced trades in your favor, you trade with them and then buy or sell the offsetting positions in the intradealer market at a fair price. With CDS, you have more options for laying off the risk.)

This had the unfortunate effect of removing a seemingly natural buyer from the corporate bond market at a time when the corporate bond market could least afford it. It is my guess that that was part of the reason why the corporate bond market bottomed out in October of 2002, rather than July of 2002. Pressure on the corporate bond market from CDS-related selling did not abate until mid-November of 2002.

As a result, there is only one major buyer of long-term corporate credit risk left in the U.S. economy: life insurance companies. Pension funds play a role in this market, as do foreign institutional buyers. So when corporate bonds do badly or well, life insurance companies are disproportionately affected.

In one sense, we are in a brave new world for both life insurance companies and the corporate bond market because the life insurance industry alone is not big enough to purchase all of the corporate bonds outstanding. Perhaps foreign institutions have filled the gap at present; if so, it will be interesting to see whether foreign capital is as patient as the life insurance industry if we have another downturn in the credit markets.

An Additional Implication of CDS

CDS unify the debt capital structure of debt-issuing companies. In the old days, companies that borrowed money from banks, or issued debt, did so in marketplaces that were separately priced. That separation allowed corporations a greater degree of wiggle room when financial times got tough. Even if the bond market temporarily shut down after a company was downgraded to junk, typically banks would still lend to them, even if the terms were more onerous.

But with the advent of CDS, the banks might lend, but they will lay all the risk on the CDS market. As more risk gets laid off, the credit default swap spreads rise. As the credit default swap spreads rise, an arbitrage opportunity appears against cash bonds.

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This leads the corporate bond market default in tandem with rising credit default swaps spreads. Finally, because of arbitrage between equity prices, equity volatility, corporate bond spreads and credit default swap spreads, even a dislocation in the equity markets can lead to trouble in the debt markets and vice versa.

Here is an example of how the world has changed. In late 2000,


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was under threat of downgrade from both ratings agencies. A downgrade from either agency would make Xerox unable to sell commercial paper, which it needed to finance its deteriorating business. The company tried to issue more commercial paper, but the auction failed, which forced it to exit the commercial paper market. To make up for the cash flow shortfall, Xerox went to its banks to tap its CP backup credit lines. The banks, distressed that what was previously considered free money for them was actually going to be put to use, went to hedge their risks in the CDS market as the CP backup lines got drawn down. The massive buying demand for Xerox CDS led the CDS spreads to widen, which spread into the corporate bond market through arbitrage and eventually led the price of Xerox common equity downward. This happened in a matter of a few days, although the effects rippled for weeks afterward.

Thus, in a panic situation, every market that provides capital to corporations fights against the corporations in a unified manner. This is very different from how the markets behaved 10 years ago. The implication for equity investors is that if you're buying the equity of debt-issuing corporations, you must be aware that in a crisis they will be more volatile than they were in the past.

Next time, in Part 2 of this column, I'll take a closer look at the changes that have taken place in the analysis of corporate bonds.

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

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.