On Credit Spreads, Stock Betas and Cycles (h/t credittrader)

This is a great document on Scribd by credittrader:

Let’s start by describing what this shows. The first chart shows the relationship between the S&P 500 and the Investment Grade (IG) bond spread. The breakout of each year’s data (i.e. vintage) is really telling because you can see a pattern:

Higher stock prices credit spreads to Treasuries lower/tighter.

But let’s take a look at what credittrader says about the stage (3) of the cycle:

As the credit cycle turned down we see credit leading equities down as the forces in (2) take hold and a vicious circle of deleveraging ‘expectations’ takes hold (whether by bankruptcy or actual debt paydown). These expectations may or may not come to fruition during this period (they did not) as we saw…

The subtext here is subtle: instead of stocks leading credit spreads, we saw things work the other way around: spreads started to widen, driving stock prices lower.

But there’s also another insight that’s very, very telling (emphasis – mine):

The cognitive bias we have been provided by the extreme drops in asset valuations has set a more ‘careful’ or risk-averse mindset into investor’s framing and while we can point to how far VIX has come from its highs, spreads from their wides, equity from its lows, TED spreads from their wides, it is worth remembering that before the 1987 crash there was NO smile in option vols (tail risk aversion) and while it would appear that this liquidity-driven rally for the ages can continue forever on the back of the Fed/TSY’s printing press, we suspect that risk premia are in a new ‘riskier’ regime and we are at the low of that new regime, rather than at the higher end of the old normal regime.

Remember when Hank Paulson talked about a repricing of risk? Well, this is the repricing in visual form, front and center.

The second chart mimics a series of charts I put together here, showing the relationship between the VIX and bond spreads across IG and high yield (HY) credit classes. But again, this chart breaks out the vintages, which layers in additional information about the relationship. Here, equity volatility rises and credit spreads tend to move right along with them.

Which usually has implications for stock prices. While the price direction is easy to gleen from these charts, the more challenging piece of the puzzle is figuring out severity – or magnitude – of the move. Here, understanding capital structure plays a role since companies that use more leverage tend to have more volatility in their stocks than ones that don’t. The best measure to use is a stock’s unlevered beta.

But before you do that, it would help to understand what beta is. From Investopedia:

Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market. For example, if a stock’s beta is 1.2, it’s theoretically 20% more volatile than the market.

So now that we know what beta measures, here’s the definition of unlevered beta:

This number provides a measure of how much systematic risk a firm’s equity has when compared to the market. Unlevering the beta removes any beneficial effects gained by adding debt to the firm’s capital structure. Comparing companies’ unlevered betas gives an investor a better idea of how much risk they will be taking on when purchasing a firms’ stock.

And here’s the formula if you’re curious (I know you are):

All you’re doing is taking the leveraged beta and dividing it by debt-to-equity ratio, with the taxes backed out. So if your company has a lot of leverage, the difference between levered and unlevered betas will be high because taxes will all be around 30-35%.

Now, if we combine the observations from stage (3),  the earlier comments about regime changes/repricings of risk,  it means betas should be heading lower with new risk/return attributes.

And as betas head lower, stock prices and returns are poised to follow suit.

This will be an interesting start to 2010…


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Filed under finance, macro, Markets, Way Forward

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