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Equity values and credit spreads: the inflation effect

A theoretical paper shows that a downward shift in expected inflation increases equity valuations and credit default risk at the same time. The reason for this is “nominal stickiness”. A slowdown in consumer prices reduces short-term interest rates but does not immediately reduce earnings growth by the same rate, thus increasing the discounted present value of future earnings. At the same time, a downward shift in expected inflation increases future real debt service and leverage of firms and increases their probability of default. This theory is supported by the trends in U.S. markets since 1970. It would principally argue for strategic relative equity-CDS positions inversely to the broad trend in expected inflation.

Bhamra, Harjoat, Christian Dorion, Alexandre Jeanneret and Michael Weber (2018), “Low Inflation: High Default Risk and High Equity Valuations”, NBER Working Paper No. 25317, November 2018.

The post ties in with SRSV’s summary lecture on macro trends.
The below are quotes from the paper. Emphasis and cursive text have been added.

In a nutshell

“Corporate defaults spike during times of low expected inflation. But so do firms’ equity valuations, despite increased default risk. [The figure below] documents these two stylized facts for the U.S. over the period 1970Q2–2016Q4.”

The discounting effect

“The nominal risk-free rate is more sensitive than the cash flows to changes in expected inflation. This ”discounting effect” arises from the stickiness of cash flows.”

“Price stickiness implies nominal cash flow growth is sticky in the short run [due maybe to longer-term contracts], and so expected nominal cash-flow growth changes less than one-for-one with changes in expected inflation. In the model, nominal cash-flow growth equals expected real cash-flow growth plus a multiple smaller than one of expected inflation. We denote this friction as sticky cash flows.”

“The nominal risk-free rate falls with expected inflation…This effect is not perfectly offset by a fall in nominal expected cash flows, because of their stickiness. [A fall in expected inflation] leads to an increase in the value of unlevered equity, but also in the present value of coupons paid to debtholders. The former effect dominates the latter, so a decrease in expected inflation increases the value of levered equity.”

“The increase in equity valuation becomes smaller for firms with more debt outstanding. The model thus implies that, in the cross-section of firms, the increase in equity prices during times of low expected inflation is less pronounced for high-leverage firms.”

The default risk effect

“The negative relation between credit risk and expected inflation…originates from the stickiness of the firm’s nominal coupons [or interest payments on longer-term loans], which are not adjusted with inflation…This stickiness… makes expected future real debt coupons [negatively] dependent on future expected inflation.”

“In the model, a fall in expected inflation affects credit spreads through distinct channels. First, a lower nominal cash-flow growth rate increases a firm’s risk-neutral default probability, which raises a firm’s credit spread. Second, lower expected inflation decreases the nominal risk-free rate, which increases a firm’s leverage ratio and thus its credit spread. Both effects induce greater credit risk as expected inflation falls.”

Basic asymmetry

“A change from moderate to low expected inflation has a greater impact than a change to high expected inflation…Hence, low expected inflation is not the mirror image of high expected inflation. We call this effect inflation asymmetry…The relation between equity valuation and inflation is non-linear…lower expected inflation increases stock prices more than higher expected inflation depresses them…Shifts in the nominal risk-free rate impact levered equity values non-linearly via a nominal discounting channel.”

“We obtain this prediction even though default probabilities are convex in the distance-to-default. The convexity implies an increase in default risk depresses the value of equity more than a decrease in default risk of the same size. But we show this effect is not sufficient to offset the asymmetry arising from the nominal-discount-rate channel. This asymmetric effect of expected inflation on asset prices is important in light of the extremely low inflation levels we have observed during and after the Great Recession.”

Empirical evidence

“We test the model predictions at the firm level. We use CRSP-Compustat merged data from April 1972 to December 2016 and exploit two measures of equity valuation: the firm’s market-to-book (M/B) ratio and the price-dividend ratio. We measure default risk as a firm’s financial-distress risk…We find that at the portfolio level, default risk and equity valuation decrease with the level of expected inflation.”

“We also find evidence that the level of debt reduces, rather than exacerbates, the sensitivity of stock prices to changes in nominal conditions. The validation of these cross-sectional predictions provides further support for our model.”


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