Curves and Corporate Credit
Just a brief note on corporate bonds. When I was a corporate bond manager 2001-2003, I learned a lot about inverted curves. It was a tough time. But what kind of inversion am I talking about?
Ordinarily, when there is little doubt over the creditworthiness of a company, the amount of incremental yield over Treasuries (spread) rises with the length of the security. This is normal, leaving aside times when the yield curve is flat or inverted, because usually, the risk of default rises with time with even the best securities, because the future is less certain than the present.
The second stage is an inverted spread curve for a given company, which given a positively sloped Treasury yield curve, might leave the corporate yield curve positively sloped, but less so than Treasuries. This indicates moderate worry over the credit risk of the company in question. (Note: during a time of credit stress, the Treasury curve is almost always positively sloped, as the Fed tends to loosen during times of credit stress.)
Next is an inverted yield curve, where short term yields are moderately higher than long term yields. This indicates significant worry over the credit risk of the company.
Finally, there is an inverted dollar (price) curve for the company. This is where default is viewed as a likelihood. The prices of the longest-dated bonds reflect current estimated recovery levels after default. Short-dated bonds may trade near par. (Par: usually $100, also usually the amount of principal remaining to be received.)
This is a qualitative/quantitative way of thinking about the corporate bond market during a time of credit stress. What percentage of the market falls into each bucket?
- Not inverted
- Inverted spread curve
- Inverted yield curve
- Inverted dollar price curve
- In default
The more names in lower categories, the greater the degree of credit stress. For companies with multiple issues of bonds, it is a simple way of characterizing the market, even in the absence of rating agencies. (As a closing aside, equity implied volatility tends to rise as a company goes down the list.)
Wait, that’s not quite a close, and not an aside. That is another way to lookat corporate bonds. As the implied volatility of the equity gets higher, the more they migrate down the list. Remember, leaving aside bank loans, usually only stable companies issue corporate debt. As their prospects get less certain, implied volatility of the equity rises, and their debt moves down the list.
October 15th, 200810:52 am at
David,
I think something is amiss with your dollar-price inversion observations. Any curve trading at a discount to par will typically see dollar-price inversion due to term structure alone. What would be amazing would be to see a positive price curve; indeed, I would suggest that below par, it’s virtually impossible except in very unusual situations. When default is highly likely, I would expect the price curve to be nearly flat, and less inverted than in all other scenarions.
October 15th, 200811:05 am at
Dan, perhaps I need to be more precise. Ordinarily dollar price curves don’t have any regular shape. A lot depends on the coupons of the bonds… were they issued when Treasuries were high or low? Were they issued during a time of credit stress or ease?
But during a time of crisis for the company, they assume a distinct shape, where the short end is anchored slightly below par, and the long end is anchored near the expected recovery value. Those bullish on the name sell the short debt and buy the long debt, because it resembles more of a free option on recovery. In default, all senior unsecured bonds get roughly the same, leaving aside bonds issued at a large discount, but typically, the longer bonds rally the most in a recovery, however unlikely.
October 16th, 20082:53 pm at
Hi David,
I am a great fan of your blog. Thanks for the insightful posts.
I have a newbie question. You expelained the issue above but i am still having a hard time to understnd. I was looking at Morgan’s CDS curve a week ago (before mufg deal) and it was inverted. Why a companies credit curve (CDS) is inverted in a distressed situation? Can you shed some light on this? Thanks very much in advance.
rower
October 17th, 20081:21 am at
The situation at MS is unclear. It has an inverted spread and yield curves, but the price curve is flattish, from what I can see.