What Should the Spread on a Corporate Bond Be? By David Merkel, (http://seekingalpha.com/article/67196-what-should-the-spread-on-a-corporate-bond-be)
 
Suppose we had seven guys in the room, an economist, a guy from a ratings agency, an actuary, a guy who does capital structure arbitrage, a derivatives trader, a CDO manager, and a guy who does nonlinear dynamic modeling, and we asked them what the spread on a corporate bond should be.
 
The economist might say whatever spread it trades at at any given moment is the right spread; no one can foretell the future.
 
The guy from the ratings agency would scratch his head, tell you spreads aren’t his job, but then volunteers that spreads are correlated with bond credit ratings on average.
 
The actuary might say that you estimate the default loss rate over the life of the bond, and the required incremental yield that the marginal holder of the bond needs to fund the incremental capital employed. Add those two spreads together, and that is what the spread should be.
 
The capital structure arb would say that he would view the bondholders as short a put from the equityholders, estimate the value of that option using the stock price, equity option implied volatility, and capital structure, and would back into the spread using that data. Higher implied volatility, higher leverage, and lower stock prices lead to higher spreads.
 
The derivatives trader would say, “Look, I sit next to the cash trader. After adjusting for a deliverability option, if cash is sufficiently cheap to to the credit default swap spread, we buy the bond and receive protection through CDS. Vice-versa if the cash bond is sufficiently rich. In general, the bond spread should be near the CDS spread.”
 
The CDO manager would say that it depends on the amount of leverage he and his competitors can employ in buying bonds for his deals, and how dearly he can sell his equity and subordinate tranches.
 
The guy into nonlinear dynamics says, “This is not a good question. There are multiple players in the market with differing goals, funding structures, and regulatory constraints. All of my friends here have the right answer under certain conditions… but at any given point in the market, each has differing levels of influence.”
 
After we tell the guy into nonlinear dynamics that he didn’t answer the question, he says, “Fine. Look at the high yield market today. Why were spreads so low nine months ago, and so high now? Did likely default costs have something to do with it? Yes, a sophisticated actuarial model would have looked at the quality of originations and seasoning, and would conclude that default costs would rise. But spreads have moved out far more than that. Have costs of holding high yield debt risen? Capital charges have risen as more downgrades have happened, and as anticipated. That’s still not enough. The loss of the bid for high yield bonds from CDOs is significant, but that is still not enough. As the credit cycle turns down, who is willing to make a bid? Who has the spare capital, and the guts to say, ‘This is the right time.’ Even if it will turn out all right in the end (the actuarial argument), I could lose my job, or get a lower bonus if I don’t time my purchases right. Hey, Actuary, do you want to increase your allocation to high yield at these levels?”
 
Actuary: “The ratings agencies have told us we only have limited room to do that. Besides, our CIO is a ‘fraidy cat; he wants his bonus in 2008. But in theory it would make sense to do so; we have a long liability structure. We should do it, but there are institutional constraints that fight the correct long-term decision.”
 
Nonlinear Dynamics Guy: “Okay, then, who does want to take more credit risk here?”
 
Derivatives Trader: “We are always net flat.”
 
CDO manager: “Can’t kick a deal out the door.”
 
Capital Structure Arb: “We’re doing a little more here, but our credit lines aren’t big. Some friends of mine that run credit hedge funds are finding that they can’t lever up as much during the crisis.”
 
The economist and the guy from the rating agency give blank stares. The Nonlinear Dynamics Guy says, “Look, high yield buyers took too much risk in the past, and now their ability to buy is impaired by increasing capital charges, and unwillingness to resist momentum. Now levered buyers of high yield credit have been killed, and there is excess supply at current levels. Rationality will return when unlevered and lightly levered buyers, or buyers with long liability structures (looks at the actuary) hold their nose, and step up and buy with real money, not short term debt.”
 
The actuary nods, and makes a mental note to discuss the idea with the CIO of the life insurance company. The economist and ratings agency guy both shrug. The CDO manager asks how long it will be before he can do his next deal. No one answers. The derivatives trader says “Whatever, I make my money in all markets” and the capital structure arb smiles and nods.
 
Nonlinear Dynamics Guy [NDG] says to the latter two, “Good for you. But what if your financing gets pulled? Many places are finding they can’t borrow as easily as they used to.” The two of them blink, grimace, and say “Our lines won’t get pulled.” Nonlinear Dynamics Guy says, “Have it your way. I hope you all do well.” At that the actuary smiles, and asks if NDG would be willing to speak at the next Society of Actuaries meeting. NDG hands him his card, and says, “Let’s talk about it later. Who knows, by the time of your meeting, things could be very different.”

Response from Bryan Goh (www.hedged.biz/tenseconds/)

The economist is always right since he is tautologically right. I am surprised he didn’t offer that the spread should be such that the returns of holding the bond should be in expectation (over default and recovery) equal to the return of holding the matching duration and currency sovereign bond. At best this transforms the problem into one of estimating default and recovery.

The ratings agency guy is assigning alphabets to spreads. At best, he can provide an ordinal valuation. A cardinal valuation is completely and utterly out of the question. Anyone who used ratings for cardinal valuation is clinically insane.

The actuary is right but simply transforms his problem from one of estimating the spread to that of estimating the probability of default and the loss given default.

The arbitrageur is right but simply transforms his problem from one of estimating the spread to that of estimating the right variance to use in his valuation of the equity option and extrapolating this with the volatility surface well beyond the neighborhood of calibration well into the wings. He is guilty of looking at data in one area, applying some cool mathematics to the data, and extrapolating it to areas where data is sparse or non-existent. That’s usually the preserve of academics, and not something the considered investor or trader would do. 

The derivs guy has not answered the bloody question. He has simply said that he will police the basis. This is typical.

The CDO manager has been driving the credit markets for the last 3 years. It doesn’t matter if he is right or wrong. Listen to him. And worry. 

I rarely make predictions because I hate being wrong. But I shall make this prediction to help make my short positions profitable. Except that you can’t wash your car to make it rain. So here goes. 

As long as there is serious skepticism about the fundamental underpinnings of the current equity market rally, as long as there are sufficient bears in the market, as long as omens of Armageddon abound, the current bull trend will be sustained as the flow of capital is modulated and drip fed into equities.

Once the perma bears throw in the towel, once the perpetual prophets of doom call an end to the bear market, once the skeptics swing to the side of optimism, then the rally will fade and the market will fall. Until then, the trend is your friend.

Take care, however, for the voices of optimism are rising. As recently as 1 month ago, investors were acutely pessimistic and expecting the worse recession since the Great Depression. With equity markets over 20% above the lows in March, suddenly the green shoots of optimism are sprouting. Once optimism rises to a crescendo, it is likely that markets will snap back to reality again.

Do I know where valuations should be? Do I know what are the fundamentals underlying the markets? At best, I have a hazy view. At worst, I haven’t a clue.

But I do know what it is like to be an emotionally driven speculator bereft of sextant or compass, and sailing in the mist.

The innovation that was accused of being a New Paradigm in the late 1990’s in the wake of the Internet boom and subsequent bust brought amongst other things the concept of Just-In-Time management of inventory and production processes. This has introduced volatility into the cash flow and earnings generation of a large swathe of the economy. The rise of financials as a share of market capitalization of equity markets around the world in the last 10 years (2008 excepting of course), has also resulted in more volatile fundamentals. As credit default rates increase as the economy continues to deteriorate, the value of contracts will be subject to increased riskiness, order books and the value of companies will become more uncertain.

Fundamentals will be volatile. This is not a call for a recovery or continued recession. It is simply an observation that the future for the underlying value of enterprises is uncertain.

Equity and credit markets price fundamentals. At least that’s the theory. Over a longer period. However, pricing is transmitted via psychology and interpretation. Pricing is therefore uncertain and volatile at its own level. If fundamentals are also volatile, however, as is the case today, what hope do equity and credit markets have of pricing in these fundamentals.

For my money, I would be prefer traders over fundamental investors. At least until things change for better or for worse.

In the recent investor surveys a number of hedge fund strategies stand out as strategies which investors expect will do well going forward and which they intend to increase their exposure to. Among these are distressed credit, global macro and CTAs. Of the three, distressed debt hedge funds had a poor 2008 whereas macro and CTAs did well. The naïve reasons for favoring distressed debt are that the world is in recession, default rates are expected to surge. Quite what condition the companies are in when they do file is another matter. I have no comment about CTA’s.

Investor expectations about macro are interesting. They expect macro to perform well in 2009 and beyond. Given the nature of macro investing, this implies that investors have some sort of macro view, at least loosely. If it is volatility in markets in general, then the probability of loss is enhanced as much as the probability of gain. Manager selection is of course paramount and what allows investors to generate more gains than losses out of volatile markets. Risk management at some level requires the investor or their manager to scale leverage to take into account underlying market volatility in the first place. These are more technical matters.

It seems that there is a tendency for investors to chase returns, to prefer strategies or managers which have been doing well recently. We can critique this approach in general or we can look specifically at the preference for macro in 2009. The clear macro trends that macro managers capitalized upon in 2008 were:

• Short rates would fall, long rates would rise. (Clear)
• Rates would reflect public balance sheets. (could take some time to manifest)
• Exchange rates would reflect risk aversion, thus strong JPY, strong USD. (not so clear)
• Credit spreads would widen precipitously. (Clear)
• Equity markets would fall. (Clear)
• Volatility would rise (Clear)
• Long rates would eventually fall as deflation risk set in. (not so clear)

Whether these were clear before the fact we cannot tell. Maybe macro managers were smart enough maybe they were lucky. We hear about the successful ones. Many of the trades were event driven, signaled by the collapse of one financial institution or the rescue of another or some narrow escape.

In 2009 what are the macro trends that managers could capitalize on?

• Short rates go to zero and stay there. (Clear)
• Long rates fall further. (not so clear)
• Weak USD (not so clear)
• Equities will fall (could take some time to manifest)
• Credit spreads recover (not so clear)
• Volatility will remain high (not so clear)

Where are the catalysts and events? There are the various rescue plans but these are for the moment limited to the housing, banking and asset backed markets in the US. Default rates will most certainly rise. But these are events more traditionally traded by ABS specialists and distressed credit investors. Where are the big macro events? One could argue that all the big macro events are behind us and that the path of the economy now follows the excruciating process of deleveraging, consolidation and repair, and releveraging. If so, where are the easy pickings for macro? Investors are likely exhibiting serially correlated expectations based on the recent performance of the strategy class and will likely end up disappointed.

Macro managers work by forming a view of the macroeconomic conditions that will unfold and then take bets to reflect those views. Whether they be in relative value or directional macro trades, whether they are long and short different parameters of the same market, most macro trades are expressed in the levels. For example, a curve steepener long 2s and short 10s, is betting on the levels of the 2 yr rates and the levels of the 10 year rates. Fewer managers trade the gamma of these markets as part of a macro strategy, an approach that adds a dimension which may be useful in a year when the traditional macro pickings are less obvious.

14 April. Retail sales numbers in the US disappointed. Retail sales less autos shrank 0.9% against a forecast of 0.0% and a prior of +0.7%. Advance retail sales were -1.1% versus a forecast +0.3% and a prior -0.1%.

PPI numbers were also reported. PPI Ex Food and Energy rose 3.8% YOY versus a forecast 4.0%. The PPI Index fell 3.5% YOY against a forecast fall of 2.2%. Monthly numbers were negative.  All in all the numbers were not indicative of inflation and if anything signalled deflation risk.

The reaction of the equity market was an immediate dip. European markets which were up about 1.5% at that point quickly fell to down 1.5%. They have since recovered.

The news is bad. Retail sales numbers missed by a mile. PPI numbers signalled deflation risk. How the markets finally close today will be interesting. If they shrug of the bad news, then sentiment remains buoyant and the rally may extend a bit furter. Otherwise the downdraft is likely to be substantial as we move into 1Q results season and have nothing but bad news to look forward to.