Caesarea Center 5 th Annual Conference, IDC, Herzliya Nikunj Kapadia, University of Massachusetts

Transcription

1 Relative Pricing of Debt and Equity Th C di M k The Credit Market Caesarea Center 5 th Annual Conference, IDC, Herzliya Nikunj Kapadia, University of Massachusetts

2 The Fundamental Syllogism 1. Debt and equity are claims on the same underlying firm. 2. Arbitrageurs actively arbitrage equity and credit markets. 3. Ergo, equity and credit markets are highly correlated.

3 Capital Structure Arbitrage Capital structure arbitrageurs take long and short positions in different instruments of a company s capital structure. Debt against stock Convertible bond arbitrage: Long convertible bond, short stock Senior debt vs. junior securities Newer strategies: Stock and CDS spread

4 Euromoney, December 2002 Can investors and bank prop desks really be so confident of the correlations between debt and equity to make a business out of arbitraging them? A few brave souls think so. This new line of business has sprung from recent fundamental changes in how credit markets trade. The number one reason why investors are getting involved in capital structure arbitrage now is because of the development of the credit default market, says Jim Vore, an executive director in credit derivatives at Morgan Stanley in New York. Even with the right theoretical models and the right views, investors weren t able to go long equity and short debt. Default swaps changed that. Credit is now much more tradable. Source: And now for capital structure arbitrage, Euromoney, December 2002.

5 Yet. Few things in investing are certain, but this one is: The Motorola bond and share prices can't both be right. If there really is a major risk that the company will end up defaulting on its $4 billion worth of bonds, its equity shouldn't be valued at $20 billion. Wall Street Journal, 1 April 2008 Why do capital structure arbitrageurs not arbitrage across Why do capital structure arbitrageurs not arbitrage across Motorola's stock and bond?

6 Stock Price vs. 5-Year CDS Spread 70 Alcoa Spread5y

7 Stock Price vs. 5-Year CDS Spread 500 Hilton Hotel Spread5y

8 Stock Price vs. 5-Year CDS Spread 1600 GM Spread5y

9 Hedge ratios The hedge ratio between the stock and CDS is computed using a model like CreditGrades. The hedge ratio is sensitive to model parameters. But that is just part of the issue: The bigger problem is that the sign of the hedge may be wrong! That is, both the stock price and CDS spread may increase (decrease) simultaneously.

10 Euromoney, December 2002 In early November credit protection on building materials group Hanson was trading at 95bp.while some traders said the correct valuation was 160bp. Its share held steady. That was the trigger that capital structure arbitrageurs were waiting for. One trader who talked to Euromoney bought 10 million-worth of Hansen s five-year credit default swap over the course of November 5 and 6 when they were at 95bp. At the same time, using an equity dl delta of 12% derived dfrom a proprietary debt equity model, he bought 1.2 million-worth of stock at $2.91 ( 4.40). Twelve days later it was all over. On November 18, with Hanson s default spreads at 140bp and the share price at $2.95, the trader sold both positions. Unusually, both sides of the trade were profitable (emphasis added)

11 How often is the sign correct? 5 business day interval: 53.8% (all), 52.3 (IG), 55.6 (HY) 10 business day interval: 58.1% (all), 56.0 (IG), 60.7 (HY) 25-business day interval: 63.7% (all), 60.8 (IG), 65.3 (HY) 50-business day interval: 68.5% (all), 66.2 (IG), 71.5 (HY) All = 200 firms over IG = 95 investment grade firms HY = 105 high yield firms

12 Sign may be wrong even with large movements in underlying price When signs are wrong (CDS spread and stock price both increase or decrease over a 2-month period): HY: The average stock return in absolute terms is 10% and the average CDS spread change is 52 bps IG: The average stock return is 7.4% and the average CDS spread change is 15.9 bps. When signs are correct: HY: The average change in stock return is 18% and CDS spread is 108 bps. IG: The average change in stock return is 12%, and CDS spread change is 30 bps.

13 GM: Stock and CDS over Spread5y PRC /2/2001 1/2/2002 1/2/2003 1/2/2004 1/2/2005 0

14 Correlations between innovations in CDS spreads and stock prices 5 business day interval: business day interval: business day interval: business day interval: Notes: Median Kendall correlation across 200 firms,

15 The Role of Arbitrageurs Which statement is more correct? 1. Debt and equity markets are not highly correlated, so they are not difficult to arbitrage. 2. Debt and equity markets are difficult to arbitrage, therefore debt and equity markets are not highly correlated.

16 Limits of Arbitrage Traditional concept of arbitrage: Risk-less, self-financing, no constraints on size of position. In practice: risky, capital-constrained.

17 Risks of the Strategy Liquidity Idiosyncratic risk Uncertain horizon of convergence

18 Liquidity Despite the size of both the CDS and equity markets, liquidity of a firm s individual id securities i matters. In 5.7% of all 1-week intervals over across 200 firms, either the stock price change was zero, or the CDS spread change was zero. Statistical tests: Cross-sectional correlation depends on credit market liquidity. The greater the number of quote providers to Markit, the lower the proportion p of zero spread changes, and greater the integration of the equity and credit market. Equity market liquidity has a secondary impact, suggesting that the credit market liquidity is the binding constraint.

19 Idiosyncratic Risk Fundamental risk that cannot be hedged. Includes risk of wealth transfers across parts of the capital structure: Firm might undertake corporate action that results in wealth lh transfers across the capital structure. Change in dividend policy Change in investment policy Merger, divestiture

20 Idiosyncratic Risk: Motorola's equity and debt Moto's leadership announced last week that it's spinning off its struggling g mobile phone business, to focus on all its unsexy (read: profitable) divisions, like police radios and cable modems. Still up in the air: How will the company's $4 billion worth of outstanding bonds be allocated between the two companies? A spokeswoman confirmed that the company isn't yet ready to say. Wall Street t Journal, 1 April 2008 It is not surprising that Motorola's stock and credit markets diverge.

21 What about profits? Given the existence it of risks, ik a convergence trade cannot simply be entered into whenever equity and credit markets diverge. Requires an evaluation of the profit potential, given the risk. Generation of private, costly information

22 Informational Sensitivity Informational sensitivity of the stock and bond: How sensitive are the securities to (private) information? Even a large stock price change would barely impact the price of an almost riskless bond. Greater the riskiness of the bond, greater the integration of the two markets. GM s stock and CDS are more highly correlated than those of Alcoa.

23 Summary The equity and credit markets are not highly correlated. But there is significant cross-sectional variation some firms have more integrated equity and credit markets than others. Most likely reason: Arbitrage is risky, and arbitrageurs are risk-averse. Integration of the two markets for any specific firm is impacted by (i) liquidity, (ii) idiosyncratic risk, and (iii) informational sensitivity of the firm s stock and bond.