The continuing equity/credit disconnect April 4, 2009 at 8:57 am

I have written several times before about the equity credit disconnect of the last few years and its implication for capital structure arbitrage models. Recently, the disconnect has reappeared, as this chart of the day from Bloomberg illustrates:

Bondholders losing faith

If there are any CSA funds left after the earlier dislocation, this would theoretically be a great time to go short equity long credit. The trouble is we now know that these dislocation can last for considerable periods, and reversion to anything close to the theoretical relationship is not guaranteed. Does this sound the death knell for capital structure models?

2 Responses to “The continuing equity/credit disconnect”

  1. Hi David, I think that the idea of Equity/Credit arbitrage on financial stocks (as opposed to something like REITs) was always pie in the sky. Due to their massive leverage, the majority (in current circumstances probably all) of a banks equity value is due to optionality. The uncertainty as to what the assets actually are let alone their value further compounding the complication of the trade; throw in the non-trivial chance of political interference in favour of one class or another (possibly at a different classes expense) and the idea that you can with any degree of precision work out what the relationship is between various classes becomes moot and given the political risk even the fall back of boundary conditions trades is not really there.

  2. Tim — Thanks for your comment. I agree completely. Models like KMV/Merton and CreditGrades never handled financials properly for all the reasons you indicate (and they find subordinated hybrid securities rather hard to deal with as their notion of default is not sophisticated enough, also complicating the picture for financials). What’s interesting is that even for industrials with simple capital structures, the models are now performing rather badly. It would be a brave trader that hedge ratios derived from a capital structure model to trade equity vs. credit in the current market…