How structural models imply distance to default
The setup in plain language: a credit spread implies a distance to default and an asset volatility (via Merton-style structural models). The equity market implies a different distance to default through its own implied vol and price level. When the two diverge by enough — typically 20%+ on implied EV — the trade is to long the cheap claim and short the rich one in duration- and notional-matched size.
Which claim to long when EV views diverge
| Bond view of EV | Equity view of EV | Trade |
|---|---|---|
| Lower (wide credit spread) | Higher (rich equity) | Long bonds, short equity |
| Higher (tight credit spread) | Lower (depressed equity) | Short bonds, long equity — rare; usually a turnaround thesis |
| Aligned | Aligned | No trade — do not invent disagreement to justify activity |
Implied enterprise value from the bonds
Implied EV from bonds ≈ (face debt) / (1 − expected loss given default) · (1 + risk premium)
Worked example: the Halvern divergence
Worked example — Halvern Materials stock implies an EV / EBITDA of about 10x. Halvern's seven-year senior unsecured bonds trade at a credit spread of approximately 4.8%, which under typical recovery assumptions implies an asset volatility around 26% — well above the 19% the equity options market is pricing. The trader's thesis: the bond market is absorbing PFAS regulatory exposure that the equity market has not yet priced. Trade construction: long Halvern seven-year bonds at a yield to maturity of about 7.3%, short Halvern equity at 0.55x the bond notional to neutralise duration on the EV mean-reversion. Catalyst: the PFAS class-action discovery deadline one hundred and twenty days out, which the trader believes will surface 10-K disclosures the equity has not absorbed.
What can break the arbitrage
What can break the trade: (1) the equity market is right — PFAS exposure is small, the credit spread tightens while the stock rises, you lose on both legs; (2) a change in the firm's capital structure (a refinancing, a buyback, a tender) re-prices both legs in ways your hedge ratios were not built for; (3) a liquidity event in either market forces you to unwind before convergence; (4) you are paid carry on one leg and pay carry on the other, and the carry differential turns negative. Always model carry across the holding period — not just the convergence payoff.
No divergence means no edge
Knowing which market is wrong and why
Sit with the ideas.
Westmoor Optical's senior unsecured bonds trade at a yield implying a credit spread that is consistent with an EV / EBITDA of about 6x given typical recovery assumptions. Westmoor's stock trades at an implied EV / EBITDA of 12x. If you believe the bond market is pricing risk the equity market is missing, which trade expresses the view?