tag:blogger.com,1999:blog-11027528911364475.post1976448326255795436..comments2024-02-18T21:10:05.205-08:00Comments on EconomPic: On the Relationship Between High Yield and EquitiesJakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.comBlogger4125tag:blogger.com,1999:blog-11027528911364475.post-6286965917895398272009-10-27T23:14:35.355-07:002009-10-27T23:14:35.355-07:00Not only were HY bonds severely underpriced (more ...Not only were HY bonds severely underpriced (more than equities) and offering equity-like returns for an asset higher on the capital structure, the S&P is also suffering (relatively speaking) under the weight of a large amount of capital raisings. So is it really a surprise that HY bonds outperformed? The same 'phenomenon has occurred with respect to correlation to CDS spreads.<br /><br />For the record, I'm with Gross and Grantham on risk assets....break lower.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-18253708446407565962009-10-27T07:05:09.868-07:002009-10-27T07:05:09.868-07:00Thanks and thanks. Hopefully the mental agony is r...Thanks and thanks. Hopefully the mental agony is repaid by some usable insights and tools?<br />Speaking of which this'll take me a little to think thru. Intellectually I get it but don't quite grasp it yet as in instinctive (think gut-level)comprehension.<br />That may have something to do with a little too much wine last night :)<br />Bottomline - I'll be back.dblwyonoreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-67936182827204950312009-10-26T14:21:56.056-07:002009-10-26T14:21:56.056-07:00slower minds my ass. it takes me hours to fully un...slower minds my ass. it takes me hours to fully understand just one of your great articles!<br /><br />DEBT vs. EQUITY<br />to me the relationship's mechanism is related to what equity truly is, levered credit. for a given company, they have the option to raise capital in one of many forms; for now lets go with issue debt or issue equity shares.<br /><br />if a company only issues equity, their capital structure is simply 100% equity and all earnings of the firm go to equity holders. as long as the company has any value, the equity has a similar value.<br /><br />as they issue debt, the equity holders get less of the earnings (a fixed or floating amount goes to the debt holders), but the issuance of debt allows less equity holders to "own" the firm so each get a larger share of those smaller earnings.<br /><br />when debt is issued, it is no longer enough for the company to have positive value. they must now have positive value is excess of the debt. in addition, as we learned this past cycle, they must also have liquidity to pay back the bondholders.<br /><br />the risk to the bondholders is the company won't be able to pay them back, BUT if they still have a claim (in most cases) to the company and their assets. <br /><br />THEORETICAL MECHANISM<br />with this in place, we can now see the value in each. the equity acts as a buffer to the debtholders. the higher the value of equity, the more buffer that you will get paid back or that if they miss payments, that the company has actual value.<br /><br />when that equity buffer decreases (as the value of the firm decreases), the value of the 'bankruptcy' option becomes smaller in value and more likely. at this point, spreads narrow.<br /><br />likewise, when the value of the firm decreases (possibly due to earnings power) then the company is less likely to be able to pay back bondholders, in which case equity values decrease as the probability of equity = 0 increases<br /><br />OTHER REASONS<br />the same people that own the debt, own the equity. think large pension plans and other institutions. when equities sell off, they are more likely to sell the corresponding debt (i.e. rebalance) to buy equity. this puts selling pressure on the price of debt. when investors are levered (think hedge funds) and there is forced selling across assets, this exacerbates the problem.Jakehttps://www.blogger.com/profile/07946497592651234440noreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-54940143125068447442009-10-26T13:13:25.697-07:002009-10-26T13:13:25.697-07:00Jake - fascinating and nicely done. Would you care...Jake - fascinating and nicely done. Would you care to speculate/explain the mechanism that seems to drive this relationship for we slower minds?dblwyohttp://llinlithgow.com/bizzX/noreply@blogger.com