This was a two part article that was published at RealMoney July?19-20, 2004:

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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.

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, Xerox (XRX) 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.

Since the bottom of corporate bond market in the 2002, corporations have enjoyed stronger profits and free cash flow. Many corporations have deleveraged. This would be reason alone for corporate spreads to tighten. But there is another factor at play here that is less known outside of the corporate market.

Two Methods of Analysis

There are two distinctly different ways to analyze corporate bonds. The first way is the old standard, which relies on fundamental analysis of a company’s financial statements. The second way relies on contingent claims theory (options theory, Merton’s model) and primarily uses market-oriented variables like stock prices and option volatility.

The basic idea behind the latter method is that the unsecured debt of a firm can be viewed as having sold a put option to the equity owners. In an insolvency, the most the equity owners can lose is their investment. The unsecured bondholders (in a simple two-asset-class capital structure) are the new “de facto” equity holders of the firm. That equity interest is most often worth far less than the original debt. Recoveries are usually 40% or so of the original principal.

Under contingent claims theory, spreads should narrow when equity prices rise, and when implied volatility of equity options falls. Both of these make the implied put option of the equity holders less valuable. Equity holders do not want to give the bondholders a firm that is worth more, or more stable.

So what’s the point? Over the last seven years, more and more managers of corporate credit risk use contingent claims models. Some use them exclusively; others use them in tandem with traditional models. They have a big enough influence on the corporate bond market that they often drive the level of spreads.

Because of this, the decline in implied volatility for the indices and individual companies has been a major factor in the spread compression that has happened. I would say that the decline in implied volatility, and deleveraging, has had a larger impact on spreads than improved profitability has.

Wider Implications for the Markets

Contingent claims models are not perfect, but they are quite good. To ignore them is foolish, but understanding their weaknesses is helpful.

Contingent claims models have a tendency to overestimate the risk of default with corporations that are overleveraged but have a long maturity debt structure. In many of these cases, the indebted corporation has a great deal of “breathing room” and often can maneuver its way out of the situation. This can offer real opportunities for buy-and-hold investors because they can buy the debt or equity at depressed levels and hold it through the apparent crisis. Doing this requires careful fundamental analysis, so if you invest in any of these situations, make sure you do your homework thoroughly.

Finally, the combination of contingent claims theory and the existence of CDS can produce other anomalies. It becomes theoretically possible to hedge CDS against common equity. Some hedge funds do this. They analyze bank debt, corporate bonds, convertible bonds, preferred and common stocks, options, warrants and other financing instruments, to find the cheapest aspect of a company’s credit structure and buy it, and find the richest aspect and sell it.

The full set of implications for the asset markets from this is unknown, partly because funds that do this are small relative to the markets as a whole. If the hedge funds that did this were too large for the markets, it would create too many feedback loops that have not yet been tested, which would have a tendency to amplify price moves in a crisis.

I can’t tell where such a crisis might lurk. The markets are relatively optimistic now. But being aware that these feedback loops could exist, can give you an edge in a crisis. The main upshot is this: Having a strong balance sheet is worth more today than it was in the past. It’s one of many reasons why I continue to focus on higher-quality companies in my equity investing.