3.3 VALUATION
3.3.2 Equity prices and volatility
regression residuals (OLS regression). Regression model I fully relies on the five Altman factors. The second fundamental model includes as a sixth variable the oil price to capture the effect of oil price shocks on the economy and on credit spreads. Furthermore, some of the independent variables are lagged. Obviously, the fitted time series of the second model tracks the historical Baa corporate bond spread even better than the original model.
cash generation benefits corporate bonds since creditworthiness improves and the required risk premium is lower. Furthermore, as the equity cushion increases through rising equity prices and more IPOs and equity volatility decreases, default probabilities and spread levels tend to fall.
Generally, equity-based models for credits have to be analyzed in the context of the leverage cycle. When the level of debt remains constant, equity as well as credit investors both benefit from rising equity prices, driven, for example, by increasing earnings estimates. When leverage is ris- ing like, for instance, between 1997 and 2000, equities tend to perform well while credit spreads widen at the same time. Conversely, deleveraging through rights issues or asset disposals, cost cutting and dividend cuts provide a favorable environment for credit, but not for equities. As Figure 3.24 shows, there is undoubtedly a relationship between equity prices and credit spreads. Yet, this relationship varies over time, depending on the current and the expected fundamental environment in the future.
Models that only relate credit spreads to equity prices therefore need to be interpreted cautiously. Assume, for example that the management of a com- pany signals its willingness to concentrate on the creation of shareholder value. Then the probability of leveraging increases substantially. If there has been no decoupling, credit investors should take that as a sign to be rather bearish.
Clearly credit and equity investors tend to look at the corporate sector from different angles. While the focus of equity markets is primarily on
Figure 3.24 Euro corporate bond spreads versus equity-market performance
Source: J.P. Morgan 1500
2000 2500 3000 3500 4000 4500 5000 5500 6000
0 20 40 60 80 100 120 140 160 180 200
Euro corporate bond spread versus government bonds
Dow Jones Euro Stoxx 50
1998 1999
2000
2001
2002 2003
earnings growth, credit investors rely on debt-related factors to make their decisions. However, if one combines both perspectives the result is a styl- ized debt–equity cycle that may support both parties in the process of decision-making. The four phases of the cycle depend on the degree of earn- ings growth (high or low) and changes in leverage (rising or falling). Changes in leverage reflect the companies’ efforts to change their capital structure as well as their ability to generate cash flows. As an example we will examine the last complete debt–equity cycle that reached from 1991 to 2003.
After the 1990/91 recession the US corporate sector underwent a period of massive restructuring. Balance sheet repair, rights issues to repay debt, asset disposals and measures to improve cash flow generation led not only to falling leverage, but also to low earnings growth rates. During this first phase of the debt–equity cycle, the ‘repair phase’ credit usually outper- forms equities. It lays the foundation for higher growth rates due to an improved ability to generate cash flows. The subsequent recovery period is beneficial for equity markets as well as credit markets, as the years 1994–97 have shown.
Phase 3 is characterized by high growth and rising leverage, as during the years 1997 to mid-2000. In this period M&A activity was rapidly acceler- ating, driven by a major focus on the creation of shareholder value. While earnings grew in this period, aggregate measures of corporate profitability like the ratio of after-tax profits of the nonfinancial corporate sector to GDP already declined. Deteriorating free cash flow measures also signaled heightened risk in the corporate sector. As one would generally expect in the expansion phase, equities performed well while credit spreads widened. In general, the high level of debt accumulated during the expan- sion makes companies vulnerable to economic downturns. Low growth and rising leverage increase the risk of defaults and rating downgrades, and are generally negative for credit as well as equity markets. The years 2000–02 are a typical example for this phase.
Figure 3.25 shows that credit spreads historically have been negatively correlated with 3-year rolling equity-market returns, as we would have expected from the Merton model. Indeed, there seems to be a longer term debt–equity cycle. But the chart also reveals a significant decoupling of equity and credit during the 1990s. Since equity-market performance alone is only temporarily able to explain variations of credit spreads, we will now analyze the impact of equity volatility on spreads. However, most of the time equity prices and implied volatility tell the same story. When stock prices are falling, demand for protection increases, and thus volatility, which is simply the price of protection, rises. The result is a strong negative correlation between equity prices and option-implied volatility. Yet the times, when both markets tell different stories, are the most interesting.
The level of implied volatility is a widely used indicator for risk appetite, and, on the individual company level, for the uncertainty related to future
earnings. It is also considered a good measure of equity-market risk, because the higher the implied volatility the higher the price of equity options, and thus the higher the cost of insuring against equity-market downturns. Corporate bond spreads reflect the compensation that the investors demand for taking on credit risk. While the debt and equity markets’ estimates of risk, as explained by the Merton model, tend to move together, temporary disconnections do occur. The combination of low levels of implied equity volatility and wide credit spreads suggests the potential for the credit spreads to tighten, as the divergence in the equity and credit market eventually gets corrected. Conversely, when implied equity volatil- ity appears high relative to credit spreads, credit markets are more opti- mistic about business risks in the corporate sector. The decoupling in the second half of 2003, however, was not an indication that credit spreads were rich relative to implied equity volatility. Rather credit markets were faster to cash in on the reduced risks in the corporate sector because of the massive balance sheet deleveraging, especially in the telecom sector.
Corporate managers were selling off assets, issuing equity and keeping cash for the debtholders, as opposed to using the cash to buy back stock for the first time in 10 years. By the end of the year, equity volatility came down significantly, closing the gap in the assessment of risk.
Figure 3.25 Three-year rolling equity-market returns versus Baa corporate spread versus treasuries
Source: Moody’s, S&P’s and Union Investment –60
–40 –20 0 20 40 60 80 100 120 140
1967 1970 19731976 19791982 1985 1988 1991 1994 1997 2000
3-year rolling return (%)
50 100 150 200 250 300
350
400
Spread versus treasuries
S&P 500 (lhs)
Moody's Baa corporate spread versus treasuries (inverted rhs)
The correlation between the debt and equity markets’ measures of risk has been extremely strong over the recent years. External shocks, for exam- ple the tragic events of September 11, 2001, the LTCM disaster in 1998 or the Asian crisis, have a substantial impact on credit spreads as well as on implied equity volatility. Figure 3.26 illustrates the relationship between implied volatility of call options on Dow Jones Euro Stoxx 50, and the spread versus government bonds of the MSCI Euro corporate bond index.
One way of interpreting implied volatility on an equity index is as the com- pensation that the investors receive for taking on equity risk. The index of credit spreads represents the additional yield investors demand for holding corporate debt over benchmark government debt. While there have at times been brief periods of divergence, these two risk measures typically move together. For example, in 1993/94 banks in the United States cleaned up their balance sheets by writing down nonperforming assets, causing the VIX index, representing the implied volatility of put and call options on the S&P 100, to fall to a historical low just above 10 percent. The decline in implied equity volatility triggered a credit spread rally. A similar thing hap- pened in 2002. Average credit spreads collapsed by half, as did option- implied volatility. So the decline in volatility was a major driver of credit spread tightening. However, one tends to find that when implied volatility
Figure 3.26 Euro corporate bond spreads versus Dow Jones Euro Stoxx 50 implied volatility of at-the-money call options
Source: MSCI and Dow Jones 0
20 40 60 80 100 120 140 160 180
1998 1999 2000 2001 2002 2003
Spread versus Government bonds (bp)
0 10 20 30 40 50 60 70 80
Implied volatility (%)
MSCI Euro corporate index – spread
Dow jones euro stoxx 50 –implied call volatility
falls below a certain threshold the effect of small changes on spreads is rather subdued.
Remember that corporate bonds can be replicated by the combination of a riskless bond and a short put on the assets of the company. Since lower rated bonds generally are closer to at-the-money than higher rated bonds, it can be expected that the increase of equity-market volatility leads to a widening of the spread differential between issues of different rating classes. This is due to the fact that the sensitivity of the bonds to changes in volatility is different. Options that trade close to at-the-money levels react more strongly given a change in volatility compared with options, which trade far out-of-the-money. The above-described relationships can be witnessed particularly well during crash scenarios in equity markets. In 1990/91, the rise in equity volatility, which was initiated by numerous profit warnings by companies, was a leading indicator of credit spreads.
Figure 3.27 shows that the subsequent rise in implied equity-market volatil- ity led to a steepening of the yield differential between high and lower rated credits. Baa and Aa rating classes are chosen to illustrate this relationship because for these rating classes the bond universe offers sufficient breadth and liquidity.
Figure 3.27 Moody’s Baa–Aa spread differential versus implied equity volatility for the S&P 100
Source: Moody’s and S&P’s 30
40 50 60 70 80 90 100 110 120
1990 1991 1992 19931994 1995 1996 1997 1998 19992000 2001 2002 2003
Baa-Aa quality spread (bp)
10 15 20 25 30 35 40 45 50
Implied volatility (%)
Moody's Baa–Aa quality spread VIX