Hello all.I have been looking into a number of Merton models for pricing credit.The premise of the approach is that equity vol affects credit spreads.It appears that there exist time-regimes and firm-specific fundamentalcharacteristics where this link is stronger and others where this linkis weaker.I was trying to come up with a complete list of such characteristics.Here is one to start the discussion:Firms with low-leverage are less affected by equity volsAlso for most of 2001 equity momentum seems to affect credit spreads.In Dec and Jan 2003 we saw a decoupling. Is this decoupling completelyexplained by the deleveragingt hat occured, or are other factors i.erisk premia etc affecting this decoupling.Are there are other macro-factors or firm-specific characteristics thataffect this link?I would be trully appreciative if i could have your thoughts.

I don't know if it is helpfull for you, but in our research we discoveredthat Equity-Bond Correlation changed dramatically.While we saw positive correlations in 98, we had a stepwise decreaseup to -0.5 negative correlation in 2002.So if you try to use equity movements to predict credit spreads, youhave to be very carefully.Flex

FlexIn your study did you make any attempt to adjust for the effects of changes in equity volatility or changes to capital structure?

No, since the result came from comparing the S&P 500 with the US Government Bond Index .I myself (in the context of Assetvalue) looked more on single stocks and risk rates (in germany). There 2i could see a negative correlation (If i talk of correlation, i mean the log returns one ).Equity volatility changed 2, it increased, but i don't see how to adjust here.Anyway, i talked to some guys and we came up with the explaination, that in former times, wheneconomie was going bad, the interest rates where decreased, thus resulting in a increase in stock pricesagain. (Interest decr -> bond up/stocks up -> positive correlation)Now we can't see any results of decreasing interest rates, due to whatever reasons (unsecurity of investors,aftershock of the high-tech bubble, bad future prognoses).Therefore we have increasing bonds vs decreasing equity. This has imo pretty high impact on asset valuecorrelations, but that's going abit too far here

There are lots of interesting effects between risk free rates and share prices, but I think you'll agree that they are all far away in spirit from the subject of this thread, which relates corporate credit spreads and share prices. For example, in times of crisis you often see increased risk aversion manifesting itself as (1) higher govt bond prices, (2) lower share prices and (3) lower corporate bond prices. This is consistent with the example you mention, but it doesn't really have much to do with Merton and credit spreads, does it?

Okay, i try to get the bow, though you are right ofcos :Since you mentioned lower corporate bond prices, this implies (i hope it does) higher yields forcorporate bonds, or higher credit spread. These credit spreads, even if other company figures will be comparableto former times, will tend to be higher due to the whole economic situation/political unsecurity.So if he focuses his research on the, lets say last 2 years, he will likely get different results than fora longer period of time. I know that holds always truth, but especially now . Just a sidenote: This negative correlation is the first to show since 1978, so this is pretty unusual . And i don't knowhow it looks before 1978, so it's possibly the first ever.

The negative correlation is something that people trading Japanese markets have become accustomed to during the 1990's and after. I think the phenomenon is very much as you described: in good times, lower rates mean lower borrowing costs for companies (higher share prices) as well as discounting earnings back at a lower rate (again higher share prices), so lower rates <=> higher share prices. On the other hand, in bad times, lower rates means that the monetary authority is worried about the economy, so lower rates is a signal of a worse economy, therefore lower share prices. So:Good times: lower rates <=> higher share pricesBad times: lower rates <=> lower share pricesThe only people that this helps are CB traders who benefit from the negative correlation between stocks and bonds, but even this, this effect is usually swamped by the additional credit spread uncertainty that goes with economic bad times.