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Credit in Downturns

Jason M. Thomas
Jason M. Thomas
Managing Director and Director of Research

By Jason M. Thomas & Mark Jenkins

• During periods of market stress, investment opportunities in leveraged credit tend to improve on both an absolute and relative basis. Equity cedes some of its upside to credit, which allows loans and bonds to outperform.

• In past market dislocations, equity prices embedded expectations of recovery that implied—and ultimately generated—even higher near-term returns on credit.

• These findings reinforce the view that investors’ exposure to credit should increase with market volatility. (See our prior research on the predictable variation in the credit risk premium through time.)

Corporate equity and credit (loans and bonds) exist as distinct asset classes with different intermediaries, models, and risk-and-return expectations. But these differences should not distract from a more basic fact: the fundamental value of stocks, bonds, and loans ultimately depends on the same stream of corporate cash flows. 

Specialization by asset class limits obvious mispricing between com-parable stocks or bonds, but it may also result in a segmentation between equity and credit in the minds of investors that actually promotes mispricing between different types of securities in the same capital structure. 

As we document below, credit often absorbs a larger share of the drop in enterprise value during downturns than would be consistent with its more senior position in the capital structure.1In technical terms, credit often responds to negative shocks as though it sits pari passu with equity rather than senior to it. 

That’s because the same “bad news” about the economy that reduces stock prices, through its negative effect on corporate earnings growth, also depresses the prices of loans and bonds by raising conditional default probabilities and loss estimates. But since this information gets incorporated into these securities’ prices by way of different intermediaries operating in segmented markets, there is no natural check on the relative magnitude of these price declines. Differences in control rights, investment horizon, and risk tolerance also contribute to the apparent willingness of equity holders to maintain “underwater” positions during downturns. 

As the market price of loans and bonds drops below its “intrinsic” value, above-average returns on credit often become a necessary condition for non-negative returns on equity. This realization not only forms the basis of distressed debt strategies, but also holds important implications for performing credit, direct lending, and overall portfolio construction.

Relative Returns Across the Capital Structure

As the senior claim on enterprise value, credit should offer lower expected returns but also exhibit less volatility and sensitivity to macroeconomic conditions than equity. Efforts to provide a more precise specification for this relationship generally build on the work of Robert Merton, who used option theory to establish put-call parity relations between the prices of debt and equity (winning a Nobel prize in the process).2 The basic intuition is that the yield on a corporate bond (or loan) and the expected return on the equity that sits below it in the capital structure jointly depend on the level and volatility of the enterprise value of the business, interest rates, and company-specific leverage.3

Empirical data generally support the idea that credit and equity prices are driven by a common risk factor and exhibit a nonlinear relationship that depends on proximity to default. Over the past decade, the average credit spread on B corporate debt has been 90% correlated with the option-implied volatility of the S&P 500 (i.e. the VIX index).4 This suggests that the VIX serves as a reasonably good proxy for the volatility of economy-wide enterprise value, which directly influences credit spreads through its effect on default probabilities and recovery rates.


Option-Implied Equity Volatility and Credit Spreads5


The nonlinear relationship is similarly obvious in the data, as shown in Figure 2, which plots the (scaled) market capitalization of a fixed sample of businesses against the credit spreads of those same businesses. Where equity market capitalization is high (the right side of Figure 2), changes in stock prices have little-to-no effect on credit spreads. Default is sufficiently remote that virtually all of the incremental gains (or losses) in enterprise value accrue to equity. In this zone, credit and equity behave almost independently of one another.


Nonlinear Relationship Between Debt and Equity6


But as can be seen in the left-hand side of Figure 2, where equity market capitalization is relatively low, small changes in market cap are associated with massive swings in spreads. When credit spreads on companies in the sample widen to 600bp, the market value of their loans and bonds becomes 53% more sensitive to changes in equity values than when spreads are 400bp. When spreads gap out to 1,000bp —typically the threshold used to denote “distress”—the sensitivity is 2.6x greater than under “normal” conditions.

Accounting for the Control Premium… 

While equity and credit prices generally move as we’d expect, empirical tests reveal that credit behaves like equity much more regularly than it should. Returns on speculative grade debt tend to be 6% per year more volatile and their spreads 300bp wider than can be explained by fundamentals.7 Loan and bond prices tend to “overreact” to bad news about the economy, causing their prices to sell at a discount relative to their claim on enterprise value.8 But given the self-contained nature of the capital structure, discounts for credit can only exist if equity becomes overvalued relative to its claim on current enterprise value.9

Defaults tend to cluster in time10 Conditional default probabilities often spike during 12-to-24-month periods of market stress and then decline steadily thereafter. Surviving the next six months often equates to surviving the next 10 years. 

In such downturns, it is natural for shareholders—especially those with a control stake—to focus more on the prospective earnings power of the business than its current value.11 Owners may therefore be unwilling to sell stock in down markets, even though it is “overvalued” on a fundamental basis, because they do not want to relinquish control or future upside. In the case of family businesses or founding owner-operators, sentimentality may also play a role.

As a result, the “option value” of equity or “control premium” rises during downturns. The equity effectively cedes part of its upside to credit through the owners’ willingness to maintain an (often deeply) underwater position in the enterprise value. An increase in the option value of equity also helps to explain why M&A volumes tend to fall with valuations, as owners ascribe a higher enterprise value to the business than can be obtained at current market prices.12

…Explains Credit’s Equity Upside 

While equity owners bet that profits in the out years will compensate for the near-term risk of ruin, creditors have no claim on those future year profits. Instead, they must focus on receiving compensation for the immediate peril. 

Consider a hypothetical business with 60/40 debt/equity capital structure (Figure 3). Based on strict payment priority, an instantaneous 30% drop in enterprise value would reduce the “intrinsic” value of the equity by 75% while leaving that of the credit unchanged.13 Of course, market prices rarely respond in this manner. The credit becomes more risky as the enterprise value drifts down towards the default boundary, which leads credit investors to demand additional subordination to bear the now-higher risk of default. As observed in Q4-2018 and other periods of heightened market volatility, credit often suffers fair value losses nearly commensurate with those of equity (Figure 4). 


Hypothetical Effects of a 30% Drop in Enterprise Value14 



Rather than plunge 75%, equity may decline by just 30%, as its “option value” rises and owners feel less inclined to sell at the market-clearing price. Credit may drop by a similar magnitude on heightened default fears. But in a self-contained system, once the credit is pushed below its intrinsic value—for whatever reason—any path for the enterprise value of the business that generates non-negative returns for equity necessarily results in equity-like upside for credit (these equity prices can be justified only if credit gets cashed out at par).  

In the example depicted in Figure 3, equity would have a positive intrinsic value if and only if the enterprise value rebounds by 25% (from $70 to $88), with any gains over this range accruing entirely to credit, raising the expected returns on secondary market purchases of loans and bonds and any new loans originated. Furthermore, this additional upside comes without extra risk for the new lenders and investors; the repricing of the debt (from $60 to $42) insulates credit from losses should enterprise value decline further.15 Default in this circumstance could actually be welcome, as the creditor may be able to gain control of the business at a steep discount to its enterprise value. (This, of course, is the strategy pursued by many distressed investors).


Credit Sells Off with Stocks in Q4-20181616


Credit’s Excess Returns in Recent Downturns 

To more precisely measure the size of the capital structure arbitrage opportunities observed in practice, we compare the response of credit and equity prices during two recent downturns—the 2008-09 Global Financial Crisis and 2015-16 energy price collapse—to their intrinsic values.17 In both of these periods, credit fell more than 30% below its intrinsic value, on average, as option value accounted for a larger share of the businesses’ equity market capitalization and credit spreads rose to compensate lenders for heightened default risk (Figures 5 and 6).


Asset Price Response to Global Financial Crisis18



Asset Price Response to Collapse in Energy Prices19

With such a large share of equity’s upside transferred to loans and bonds, the average price returns on credit exceeded 65% in the three months following the trough in enterprise value in both periods. Equity recovered, validating the decision of (many) shareholders to hold onto the business despite negative intrinsic net worth, but as the junior claim, those returns were only realized because credit performed so well.  

In the three months following the Lehman Brothers bankruptcy filing, the aggregate enterprise value of speculative grade companies in the U.S. dropped by 42%, on average. Over this period, the average price of the credit owed by these businesses fell by 36%, relative to a 46% drop in the average equity values of the same set of companies. While equity declined by more than credit, the relative magnitude was absolutely nothing like that implied by the structural model, which suggests that the peak-to-trough decline in the intrinsic value of credit was less than 10%, 20 after accounting for the decline in interest rates, average debt in capital structures, and the weighted average maturity of liabilities for companies in the sample. Effectively, equity bore just 60% of the losses implied by the model (Figure 5).

There was a flip side to this coin, of course, as the decline in the intrinsic value of credit dramatically increased expected returns on secondary market purchases of loans and bonds, as well as new loans extended during this period of stress. 

As in the hypothetical example above, equity prices assumed a massive rebound in enterprise value that would necessarily result in equity-like excess returns on credit. From mid-December 2008 to May 2009, credit prices rose 34% relative to a 20% increase for equity. Credit also bottomed out three months in advance of equity (December 2008 relative to March 2009) and snapped back in value much more quickly. While the 80% total annualized returns on credit between December 2008 and May 2009 would not have been possible had enterprise values not rebounded, the discounts to intrinsic value provided implicit subordination that ensured that the probability of loss never rose above 7%, on average, either.

Much the same dynamics were observed when the crash in energy prices depressed industry enterprise values in 2015-16. Between November 2015 and February 2016, the enterprise value of speculative grade companies in the energy sector declined by 38%, on average. Over the same period, the mark-to-market value of the debt owed by these businesses dropped 33%, while their equity fell 44%. Again, these price declines were far closer to pari passu than would be implied by the capital structure. The peak-to-trough decline in the intrinsic value of credit was just 5.2%, partly because the decline in interest rates over this period increased the present value of high-yield bonds. From peak-to-trough, equity bore just over half of the losses implied by the model (Figure 6).  

Over the next four months, as crude oil prices stabilized and then rebounded, energy credit generated price returns of 65%, well in excess of the 54% gains on energy equity over the same horizon. After accounting for coupon interest, the internal rates of return on a diversified portfolio of speculative grade energy credits exceeded 80% in the next six months. Again, these returns came despite the significant degree of implicit subordination provided by the discounts to intrinsic value, which would have allowed secondary market purchasers to break even in the event that industry enterprise value fell by an additional 40%. 


When markets take a turn for the worse, credit investment opportunities tend to improve on both an absolute and relative basis. For control-oriented investors, downturns increase distressed situations, where underwater shareholders are flushed out of their positions. For tactical asset allocators, credit offers a more attractive risk-return profile for a given business or industry, with equity-like upside combined with traditional levels of downside protection. 

Credit tends to take bad news about the economy especially hard, selling off by far more than can be explained by its position in the capital structure. Whether the price misalignment is explained by differing investment horizons, control rights, risk aversion, or market segmentation, its effect is to transfer some of equity’s upside to credit. In past downturns, credit prices fell 30% or more below intrinsic value, leading directly to 80% annualized total returns in the months following the market bottom. 

Investors betting on a rebound in equities during downturns should take a moment to consider what that assumed rebound would mean for the returns on the loans and bonds in those same capital structures.



Mark Jenkins

Mark Jenkins is a Managing Director and Head of Global Credit based in New York. He is also a member of Carlyle’s Management Committee.

Prior to joining Carlyle, Mr. Jenkins was a Senior Managing Director at CPPIB and responsible for leading CPPIB’s Global Private Investment Group with approximately CAD$56 billion of AUM. He was Chair of the Credit Investment Committee, Chair of the Private Investments Committee and also managed the portfolio value creation group. While at CPPIB, Mr. Jenkins founded CPPIB Credit Investments, which is a multi-strategy platform making direct principal credit investments. He also led CPPIB’s acquisition and oversight of Antares Capital and the subsequent expansion in middle-market lending. Prior to CPPIB he was Managing Director, Co-Head of Leveraged Finance Origination and Execution for Barclays Capital in New York. Before Barclays, Mr. Jenkins worked for 11 years at Goldman Sachs & Co. in senior positions within the Fixed Income and Financing Groups in New York.

Mr. Jenkins earned a Bachelor of Commerce degree from Queen’s University. He served on the boards of Wilton Re, Teine Energy, Antares Capital and Merchant Capital Solutions.


Jason M. Thomas

Jason Thomas is a Managing Director and Director of Research at The Carlyle Group, focusing on economic and statistical analysis of the Carlyle portfolio, asset prices, and broader trends in the global economy. Mr. Thomas is based in Washington, D.C.

Mr. Thomas serves as the economic adviser to the firm’s corporate private equity and real estate investment committees.  Mr. Thomas’ research helps to identify new investment opportunities, advance strategic initiatives and corporate development, and support Carlyle investors. 

Previous to joining Carlyle, Mr. Thomas was Vice President, Research at the Private Equity Council. Prior to that, he served on the White House staff as Special Assistant to the President and Director for Policy Development at the National Economic Council.  In this capacity, Mr. Thomas served as the primary adviser to the President for public finance.

Mr. Thomas received a B.A. from Claremont McKenna College and an M.S. and Ph.D. in finance from George Washington University where he studied as a Bank of America Foundation, Leo and Lillian Goodwin Foundation, and School of Business Fellow.

  • 1. C.f. Berndt, A. et al. (2017), “Corporate Credit Risk Premia,” SIEPR Working Paper No. 17-048; Berndt, A. (2015), “A Credit Spread Puzzle for Reduced-Form Models,” The Review of Asset Pricing Studies; and Huang, J. and M. Huang, (2012), “How Much of the Corporate-Treasury Yield Spread is Due to Credit Risk,” The Review of Asset Pricing Studies.
  • 2. Merton, R. (1974), “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,” The Journal of Finance.
  • 3. If y is the operating earnings yield on the enterprise value, A, i is the interest rate on the debt, D, and r is the expected return on equity, E, then equilibrium can be specified as r=A/E (y-i)+i
  • 4. When measured at a monthly frequency.
  • 5. Bloomberg; ICE Bond Indices, December 2018.
  • 6. Carlyle; Bloomberg; ICE Bond Indices, December 2018.
  • 7. Bao, J. and J. Pan (2013), “Bond Illiquidity and Excess Volatility,” Review of Financial Studies.
  • 8. Berndt, A. et al. (2017), “Corporate Credit Risk Premia,” SIEPR Working Paper No. 17-048
  • 9. Enterprise value is not directly observable. We estimate it as the combined market value of debt and equity.
  • 10. Das, S. et al. (2007), “Common Failings: How Corporate Defaults are Correlated,” The Journal of Finance.
  • 11. Management is incented to focus on raising liquidity buffers, avoiding insolvency, and living to fight another day.
  • 12. Axelson, U. et al., (2013), “Borrow Cheap, Buy High? The Determinants of Leverage and Pricing in Buyouts,” The Journal of Finance.
  • 13. Intrinsic” value is a term of art in options markets that measures the current liquidation value of an option.
  • 14. For illustrative purposes only.
  • 15. Although the enterprise value would still fully cover the debt, the risk of default has increased massively as a further 14% decline would begin to eat into principal.  It should be no surprise that a new investor would demand more subordination to reduce the risk of default.
  • 16. Carlyle; Bloomberg; ICE Bond Indices, December 2018.
  • 17. These intrinsic values are derived from a structural model calibrated to the aggregated equity and credit returns, interest rates, and book leverage of the entire ICE H0A0 and H0EN indexes for the 2008-09 and 2015-16 periods, respectively.
  • 18. Structural Model. Data from ICE and Bloomberg, December 2018.
  • 19. Structural Model. Data from ICE and Bloomberg, December 2018.
  • 20. If 10% seems small, think of it as a 20% implied default rate with a 50% average recovery value.
Economic and market views and forecasts reflect our judgment as of the date of this presentation and are subject to change without notice. In particular, forecasts are estimated, based on assumptions, and may change materially as economic and market conditions change. The Carlyle Group has no obligation to provide updates or changes to these forecasts.

Certain information contained herein has been obtained from sources prepared by other parties, which in certain cases have not been updated through the date hereof. While such information is believed to be reliable for the purpose used herein, The Carlyle Group and its affiliates assume no responsibility for the accuracy, completeness or fairness of such information.
References to particular portfolio companies are not intended as, and should not be construed as, recommendations for any particular company, investment, or security. The investments described herein were not made by a single investment fund or other product and do not represent all of the investments purchased or sold by any fund or product.

This material should not be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any action based on this material. It is for the general information of clients of The Carlyle Group. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors.