Credit spreads and equity levels

 

Credit investing and equity investing are closely aligned. A bond is a put on the firm. There is only a coupon return and the return of capital. If the firm value declines, there is a decline in the value of the bond. Equity is a call option in the residual value of the firm. Both are associated with the underlying value of the company. Hence, if overall equity values increase, the risk and spread for investment and high yield should decrease. If equity markets decrease, the residual value of the firm declines and the risk to bonds will be displayed in increasing bond spreads. 

We have taken a different look at this relationship through a scatterplot with a line tracking the relationship through time. It provides a different story for how this relationship moves through time and with the level of equities.

Using data from 2012 to June 24,2022, the pandemic dominates the relationship between equites and bonds. There was a credit crisis that far exceeded the equity downturn as measured by spreads. The current equity sell-off creates a similar credit spread pattern, but it seems muted relative to the past at least for investment grade bonds. 

The more interesting relationship is the shift of the trade-off as equity levels increase. Equity markets move and then credit risk adjusts to a new level. There is not just one equity-credit spread relationship.