Minyan Mailbag: Measuring Corporate Bond Risk
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.
Dear Professor Succo,
I recently read an interesting description of the options theory/Merton's model for valuing corporate bonds. The author contends that more and more of corporate bond investors are gravitating to this method as opposed to good old fashioned funds (buying on cash flow models). These models include market dominated variables like implied option volatility, etc....
Do you believe that the recent strength in the corporate market could at least be explained by the low level of financial market volatility, and how this would impact Merton-like models and hence corporate bond investor behavior?
Minyan James Dailey
There is a positive relationship between risk and return: the higher the risk, the more return demanded by investors to compensate. This is a primary driver in asset allocation: what is the appropriate "risk premium" to apply to an asset.
The Merton model attempts to establish a relative risk measure for valuing corporate bonds using the volatility of the asset as the risk measure.
As I understand the model, low equity market volatility would be an input that would make credit spreads look less risky. Lower equity market volatility has been the result of the extreme liquidity as provided by the Fed (the by-product of this is higher debt, which in the long-run should increase volatility). But by the same token, higher risk-free bond volatility would be an input that would make credit spreads look riskier, so those two things probably flatten out.
So overall, I think it's just the liquidity in the system that has forced people to compress credit spreads to get returns.
The Merton model, as described, basically infers that the lower the volatility of an asset, the less risk, and thus a higher price for that asset can be justified.
So there is a more important question: is the premise that volatility is a good measure of risk for corporate bonds (or any other asset) sound?
In my opinion, volatility is only one very narrow measure of risk. I have described volatility in some of my tutorials: it is basically a linear calculation that estimates how much an asset will move over a certain period of time based on historical data.
It is only one number, so it is only one dimensional in its description. It says nothing of gap risk (something called kurtosis, which measures the tails of the distribution of returns).
More importantly, it describes nothing of potential fundamental risks that are not incorporated in historical price returns. A corporate bond holder ultimately only really cares about one risk, that of default. The volatility of an asset has only at best an indirect relationship with this risk.
In addition, volatility (or standard deviation) is a linear calculation, simply extrapolating what happened in the past into the future.
Again, this gets into the chaotic nature of markets and the poor job that linear math does in incorporating this. It is like the tail wagging the dog: does low volatility in the past mean that there is less risk in the future? If so it would mean that the relationship between variables that affect prices is constant. I don't believe that to be the case.
I suspect that the volatility of corporate bonds is more important to buyers today because they use leverage in buying them (through hedge funds).
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