Fallen Angels and crossover credits are often targeted by alternative investor groups like hedge funds and risk arbitrageurs who speculate on the mispricing between the various financing instruments of a company.

Characteristics of Fallen Angels:

• High leverage in respect to operating cash flows
• Weak industry trends lead to low and unpredictable operating cash flows
• A further deterioration of the operating performance is not sustainable with the financial profile
• Loss of market share
• Not enough liquidity to support the ongoing business
• Decreasing asset quality
• Management is unable to identify profitable business units
• Weak and complex debt structure
• Unfavorable regulatory environment and lack of support by the government (mainly for European companies)

A correlation between total returns of high yield and treasury bonds shows that interest rate risk can certainly not be neglected by high-yield investors. The mid-1990s serve as a good example. High yield and treasury returns had a quite high correlation in an environment of low default rates and tight credit spreads. In 2003 an increased correlation could be observed again when spreads were approaching historical lows and default rates were falling.

High-yield sensitivity to interest rates is a function of credit risk. This means that the high-yield upper tier (BB/BB) segment’s correlation to 10-year treasuries is higher than for lower tier credit (B and below). Duration management in high-yield portfolios will have a positive performance contribution. Particularly crossover credits and BB’s total returns will be also determined by the movements of interest rates.

During times of low default rates, historically tight spreads and low interest rates it is worthwhile to analyze the duration contribution of various sectors to the high-yield index. In a scenario of rising interest rates, sectors with tight spreads and a high average duration should be watched closely due to a high underperformance potential.

Whenever the equity risk premium falls below current spread levels, there is a quasi-arbitrage opportunity between corporate bonds and equities. After a long period with a positive equity credit premium, the picture changed in 1999, signaling the height of the equity bubble. The interpretation of this was that expected returns on corporate bonds versus equities were extremely attractive. While corporate bonds actually outperformed equities by far between 2000 and 2002, those years were characterized by a massive widening of credit spreads. Due to the bursting of the tech bubble and the credit spread tightening since fall 2002, the gap has closed.

One approach to identify relative value between the above-mentioned asset classes is to compare risk premia. For corporate bonds this is equivalent to the spread over government bonds. The comparison versus equities requires the estimation of the equity risk premium, that is the difference between the expected rate of return on the stock market and a risk-free interest rate, usually long-term government bond yields. While there are differences in the sector structure of the equity and corporate bond markets, for example with respect to technology exposure, the equity credit premium may nevertheless provide valuable insights into the relative valuation of both markets. This is because risk factors such as economic growth, risk aversion and implied equity volatility influence both markets in a similar manner.

The rapid growth of the European corporate bond market since 1997 has promoted the acceptance of corporate bonds as a separate asset class. Therefore, identifying relative value not only between equities and government bonds, but also relative to corporate bonds, has become a central task of asset allocators. But, of course, this analysis is also relevant from the perspective of a pure fixed income investor. Not only does it help to assess the outlook for credit spreads in general, but also to decide on the beta or, in other words, the aggressiveness of a pure corporate bond portfolio relative to its benchmark. Although it has been common use to compare equities and government bonds, it is far less common to compare equities and corporate bonds.

Remember that corporate bonds can be replicated by the combination of a riskless bond and a short put on the assets of the company. Since lower rated bonds generally are closer to at-the-money than higher rated bonds, it can be expected that the increase of equity-market volatility leads to a widening of the spread differential between issues of different rating classes. This is due to the fact that the sensitivity of the bonds to changes in volatility is different. Options that trade close to at-the-money levels react more strongly given a change in volatility compared with options, which trade far out-of-the-money. The above-described relationships can be witnessed particularly well during crash scenarios in equity markets. In 1990/91, the rise in equity volatility, which was initiated by numerous profit warnings by companies, was a leading indicator of credit spreads.

The subsequent rise in implied equity-market volatility led to a steepening of the yield differential between high and lower rated credits. Baa and Aa rating classes are chosen to illustrate this relationship because for these rating classes the bond universe offers sufficient breadth and liquidity.

The correlation between the debt and equity markets’ measures of risk has been extremely strong over the recent years. External shocks, for example the tragic events of September 11, 2001, the LTCM disaster in 1998 or the Asian crisis, have a substantial impact on credit spreads as well as on implied equity volatility. Consider the relationship between implied volatility of call options on Dow Jones Euro Stoxx 50, and the spread versus government bonds of the MSCI Euro corporate bond index.

One way of interpreting implied volatility on an equity index is as the compensation that the investors receive for taking on equity risk. The index of credit spreads represents the additional yield investors demand for holding corporate debt over benchmark government debt. While there have at times been brief periods of divergence, these two risk measures typically move together. For example, in 1993/94 banks in the United States cleaned up their balance sheets by writing down nonperforming assets, causing the VIX index, representing the implied volatility of put and call options on the S&P 100, to fall to a historical low just above 10 percent. The decline in implied equity volatility triggered a credit spread rally. Asimilar thing happened in 2002. Average credit spreads collapsed by half, as did optionimplied volatility. So the decline in volatility was a major driver of credit spread tightening. However, one tends to find that when implied volatility falls below a certain threshold the effect of small changes on spreads is rather subdued.

The level of implied volatility is a widely used indicator for risk appetite, and, on the individual company level, for the uncertainty related to future earnings. It is also considered a good measure of equity-market risk, because the higher the implied volatility the higher the price of equity options, and thus the higher the cost of insuring against equity-market downturns. Corporate bond spreads reflect the compensation that the investors demand for taking on credit risk. While the debt and equity markets’ estimates of risk, as explained by the Merton model, tend to move together, temporary disconnections do occur. The combination of low levels of implied equity volatility and wide credit spreads suggests the potential for the credit spreads to tighten, as the divergence in the equity and credit market eventually gets corrected. Conversely, when implied equity volatility appears high relative to credit spreads, credit markets are more optimistic about business risks in the corporate sector. The decoupling in the second half of 2003, however, was not an indication that credit spreads were rich relative to implied equity volatility. Rather credit markets were faster to cash in on the reduced risks in the corporate sector because of the massive balance sheet deleveraging, especially in the telecom sector.

Corporate managers were selling off assets, issuing equity and keeping cash for the debtholders, as opposed to using the cash to buy back stock for the first time in 10 years. By the end of the year, equity volatility came down significantly, closing the gap in the assessment of risk.

Credit spreads historically have been negatively correlated with 3-year rolling equity-market returns, as we would have expected from the Merton model. Indeed, there seems to be a longer term debt–equity cycle. But the chart also reveals a significant decoupling of equity and credit during the 1990s. Since equity-market performance alone is only temporarily able to explain variations of credit spreads, we will now analyze the impact of equity volatility on spreads. However, most of the time equity prices and implied volatility tell the same story. When stock prices are falling, demand for protection increases, and thus volatility, which is simply the price of protection, rises. The result is a strong negative correlation between equity prices and option-implied volatility. Yet the times, when both markets tell different stories, are the most interesting.

Phase 3 is characterized by high growth and rising leverage, as during the years 1997 to mid-2000. In this period M&A activity was rapidly accelerating, driven by a major focus on the creation of shareholder value. While earnings grew in this period, aggregate measures of corporate profitability like the ratio of after-tax profits of the nonfinancial corporate sector to GDP already declined. Deteriorating free cash flow measures also signaled heightened risk in the corporate sector. As one would generally expect in the expansion phase, equities performed well while credit spreads widened. In general, the high level of debt accumulated during the expansion makes companies vulnerable to economic downturns. Low growth and rising leverage increase the risk of defaults and rating downgrades, and are generally negative for credit as well as equity markets. The years 2000–02 are a typical example for this phase.