Swedroe: Contagion & Corporate Credit

Contrary to what most investors believe, empirical studies of corporate bond premia have found that only a small fraction of observed credit spreads can be explained by expected losses from defaults.

For example, research has found that the contemporaneous return of the S&P 500 Index is highly significant when determining the changes in credit spreads across bond portfolios, with the sign being negative. The relationship increases as you move to lower-grade credit categories.

Jennie Bai, Pierre Collin-Dufresne, Robert Goldstein and Jean Helwege—authors of the study “On Bounding Credit-Event Risk Premia,” which appeared in the March 2015 issue of The Review of Financial Studies—examined the historical evidence to determine how much of the spread in corporate bonds was related to credit-event risk, and how much was related to contagion-event risk.

Defining A Credit Event

The study, which covered the period 2001 through 2010, defined a credit event as having occurred if the credit default swap (CDS) spread (or the firm-level bond yield spread) jumped by 100 basis points or more within a three-day window. They also required that firms start the pre-event period with a CDS spread of no higher than 400 bps, or with a bond price of no lower than $80.

The authors chose these criteria because, even though all the bonds in their sample were investment grade prior to the event, ratings sometimes lag the market. In other words, investment-grade bonds with high spreads may no longer actually be perceived as investment grade by market participants. The study covered 128 events using the CDS sample and 330 events using the corporate bond data.

Consistent with prior research, the authors found that credit-event risk explains only a small percentage of the premium. A large majority of the premium is explained by contagion risk. Credit markets tend to perform poorly when the equity market portfolio performs poorly.

Bond Default Characteristic

The authors further found that many of the firms that experienced a large jump in credit quality then went on to experience several subsequent jumps. They also noted the majority of corporate bonds that default do so while holding a speculative-grade rating, and carried such a rating for a considerable time before default occurred.

Stated another way, defaults aren’t a huge surprise, but rather the result of a long, slow decline in firm value. Consistent with the default of these “fallen angel” bonds not being a big surprise to market participants, the authors found that the aggregate indexes don’t respond on the default days of junk bonds.

The main findings from the study can be summarized as follows:

• There is a “significant relationship” between the negative events (as measured by the jump in the CDS premia) and the average spread on the corporate bond index.
• The corporate bond index, as measured by Merrill Lynch’s investment-grade bond index, falls significantly on the event day.
• Credit events also are associated with negative stock market returns. In particular, the average stock market return on event days is negative 0.77 percent, and is statistically significant.
• The corporate bond market, on average, drops 0.15 percent during a credit event and CDS spreads widen. However, the yield on Treasury bonds falls significantly during negative event episodes, which is consistent with a flight-to-quality effect.
• Firms with higher pre-event credit risk tend to be associated with a more significant market move.

Contagion Risk Premia Higher

The authors found that credit-event risk premia are very small, approximately 1 basis point, while contagion risk premia are significantly larger. They also found that the firms suffering a credit event are typically quite small, with their average weight equal to 0.22 percent of the Barclay’s aggregate (investment-grade) corporate bond index. They concluded: “The implication is that contagion risk is economically significant, even for medium-sized firms.”

The authors carefully note: “Since only credit-event risk, and not contagion risk, can explain large short-maturity spreads, our findings suggest that short-maturity spreads are not due to credit-event risk, but rather to noncredit factors, such as liquidity and tax effects.”

In addition, the authors concluded that the failure to account for the contagion risk leads to an upward bias in the estimated credit-event premia—and that bias is likely very large.

What Does This Mean For Investors?

For investors, the implication of this study is that all but short-maturity corporate bonds contain equitylike risks. And the lower the credit rating, the greater the contagion risk. Thus, investors who choose to include an allocation to either high-yield bonds or longer-term investment-grade bonds should consider them to be hybrid instruments, combining characteristics of both Treasurys and equities.

Investors should also consider the fact that these bonds tend to become more equitylike at exactly the wrong time, when the risks of equities show up. Thus, those who choose to include an allocation to these types of bonds should make sure they are accounting for the equitylike risks inherent in them. In other words, consider some portion of them to be equities.

In short, the lower the credit rating and the longer the term of the bond, the more you should think about a portion of it as an equity allocation. Failure to do so could result in investors exceeding their ability and willingness to take risk during bear markets. That, in turn, could lead to either forced, or panicked, selling.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.