Volatility and Credit Spreads

anxiety roller coaster stressAs plan sponsors broaden their horizons on the fixed income front, corporate bonds are playing a growing role in their portfolios. A new piece of research looks closely one important driver of corporate bond spreads – market volatility. Investors have long noticed the inverse relationship between market swings and spreads of corporate bonds – the question is, why? A new paper by Columbia Business School’s Aleksey Semenov takes a close look at the interrelationship between corporate investment decisions (the left-hand side of the balance sheet) and debt financing (the right hand side of the balance sheet). The paper was presented at last week’s Northern Finance Association Conference held in Mont Tremblant, Quebec, September 16-18 2016.

Semenov’s extended model incorporates the borrowing, investment, payout, and bankruptcy decisions of risk-averse agents. The paper draws a picture of corporate reactions to market volatility such as flight to quality, gambling for resurrection, and bankruptcy for profit. Those decisions directly affect debt prices.

It’s a dynamic that clearly affects credit spreads. At the same time, Semenov finds, “contrary to common beliefs, credit spreads can be lower when the volatility of risky assets is higher.” This occurs, he notes, when the value of the company’s assets is high relative to the amount of debt, making the payout rate lower and driving the company to make less risky investments at times when risky assets are more volatile. “This conservative behavior decreases the probability of bankruptcy and leads to lower credit spreads,” he concludes.

Interesting findings for investors seeking a better understanding of volatility in their fixed income portfolios.

You can read the full paper here.