It is an observed phenomenon during periods of both volatile and falling equity prices, credit spreads on bank and corporate debt almost invariably rise. Many investors are currently experiencing illiquidity in the tradable debt securities they hold. The illiquidity is simply a function of sellers not adjusting to the new level of credit spreads and buyers lacking confidence to buy because of the uncertainty in markets. The market only trades where the most desperate seller and the bravest buyer meet in times of uncertainty.
The relationship between credit spreads and equity prices is well documented in theories proposed by Nobel prize winning economist Robert C Merton. These theories were developed into practical use by a company called KMV Corporation that marketed a model translating a company’s equity price and volatility into a measure of its expected probability of default over a one year period. The KMV model gained popularity in the late 1990’s as an alternative predictive tool for credit managers to rival the major credit ratings agencies. KMV was sufficiently successful as a business that it was acquired by Moody’s Investor Services in 2002.
Merton’s theory behind the KMV model is both simple and intuitive. It argues if a company’s share price falls to zero (or close to zero) then it will default. The probability of default depends on how many standard deviations of share price movements its current share price is from falling to zero. The standard deviation of the share price movement is related to the volatility of the share price with a higher share price being further from the zero point than a lower share price. The theory relies on an assumption of efficient markets where all known information is accounted for in the equity price of the company and if the price is volatile this is due to either small news items making a large difference to the prospects of a company due to its specific circumstances or a general market environment where there are substantial news flows making large differences to the outlook for all companies (such as is the case currently with COVID-19).
When equity markets fall violently, it is a double whammy as the share price gets closer to zero and the standard deviation of share price movements also increases, meaning the number of standard deviations between the current share price and zero decreases due to both of these factors. This means the default probabilities can increase substantially under Merton’s theories. These increased probabilities of default are reflected in larger credit spreads as investors justifiably want to be compensated for the additional risk.
As an example of recent credit spread movements on 4 April and 7 April two Canadian Banks (Bank of Montreal and Toronto Dominion Bank) launched AAA rated 3 year covered bonds at a spread of 125bps when the equity market was a little lower than today, but a lot more volatile. On 15 April, a third Canadian Bank (Royal Bank of Canada) launched a AAA 3 year covered bond at a spread of 100bps. Essentially these three issues are largely generic, with the difference in pricing really being due to a reduction in uncertainty over the last two weeks as reflected in more stable equity markets. The implied credit spreads for Australian major bank 5 year FRN’s referenced to the above new issues is a retreat from a peak of around 200bps to around 150bps as the volatility in the equity markets has decreased. This is compared with credit spreads of around 80bps late last year for Australian major bank 5 year FRN’s.
