The long-awaited shift in monetary policy appears to be resulting in a new volatility paradigm. That could have adverse consequences for US corporate bonds even if economic data holds firm, argues Joubeen Hurren.
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Financial markets appear to have entered a new volatility regime this year; something that could have major ramifications for the price of almost every asset class, none more so than US corporate bonds.
As the chart below demonstrates, US stock market volatility, as measured by the Vix index, had been on a declining trend since the summer of 2009. However, after hitting an all-time low in October 2017, the index has begun to rise.
Chart 1. US stock market volatility on the rise
At first glance, the recent increase in the 200-day moving average may appear nothing out of the ordinary. After all, during its eight-year-long decline in the wake of the financial crisis, the index regularly spiked sharply higher – and considerably above its current level – most notably in October 2011 when the euro zone sovereign debt crisis was uppermost in investors’ minds.
That on each occasion volatility quickly subsided was largely due to the actions of the world’s leading central banks, with the Federal Reserve (Fed), European Central Bank, Bank of Japan and others having been only too willing to loosen monetary policy at the first sign of trouble in financial markets.
A decisive shift by central banks?
While it is still too early to know for sure if the pick-up in volatility since last October marks a decisive shift, there are strong reasons to believe it does. Crucially, what differentiates this period of rising volatility to others during the past eight years is that it has coincided with a very different monetary policy environment. The process of tightening monetary policy is already well underway in the US and several other countries, and is set to begin in the euro zone in 2019.
Whereas until recently central banks were preoccupied with the threat of deflation as their economies struggled to rebound after the financial crisis, suddenly inflation is seen to be the bigger threat. This is significant, as it means the Fed and others are much less likely to ride to the rescue of risk assets. Furthermore, it appears financial markets recognise this. It is striking, and surely not random, that since volatility began to pick up the price of pretty much every asset class has fallen. Were volatility to continue to rise, as seems distinctly possible, there is a clear danger the sell-off in risk assets could intensify.
Chart 2 shows how closely high-yield bond spreads tracked US equity market volatility between 2014 and 2017. This close relationship is not coincidental. Assets such as equities and corporate bonds are highly correlated to the Vix for good reason: they all reflect market sentiment. The chart also provides a sense of the extent to which bond spreads and the Vix have decoupled this year. This suggests the sell-off in credit markets could have much further to go.
Chart 2. High yield spreads decouple from Vix
he fact corporate bonds are bought largely for the relative security of the income streams provided by their coupon explains why credit could be especially vulnerable to a new volatility regime. When purchasing a bond that is trading at par with say a three per cent coupon, the investor’s overriding objective is to secure the three per cent return offered. While they are not necessarily expecting to make much more than that each year, by the same token they have a much lower tolerance for losses.
The upshot of this is that credit is especially sensitive to changes in volatility. That three per cent coupon is likely to be much more highly prized when volatility is low than in an environment where prices are gyrating wildly. The same is true of equities but to a much lesser extent, since in most cases investors do not buy shares just for their dividend yield.
Credit spreads: inadequate compensation
To quantify the extent to which corporate bond spreads have decoupled from the Vix this year, it is possible to construct a linear regression mapping the historical relationship between these two variables as we have done in chart three.
Chart 3. Linear regression of US high yield spreads vs Vix
The following equation can be derived from the chart above:
High yield spread (basis points) = (36.9 * Vix) - 124
The current level of the Vix is 21.5 – which also happens to be close to its average over the past 30 years – implying a spread of 669 basis points. That compares with the present level of 425 (denoted by the red triangle). Looking ahead, if we assume the Vix moves within a five-point range either side of its current level, this would imply high yield bond spreads ranging between 430 and 799 basis points. Likewise, if we regress investment grade spreads against a Vix of 20, they should be closer to 190 basis points compared with 140 presently.
It is not just the fact corporate bond spreads have decoupled from the Vix that causes us to be bearish of credit. After all, volatility is picking up largely because the US economy is moving towards the latter stages of the current cycle. That in turn is leading to a change in the monetary policy regime, which markets are still struggling to adapt to.
Whereas until recently we have witnessed accelerating growth, benign inflation and loose monetary policy – a perfect mix for credit – now it looks like growth may be peaking, inflation accelerating, and monetary policy tightening, all of which are bad for credit.
Given this backdrop, we believe credit spreads do not compensate investors adequately for the risks. US corporate bonds, having outperformed other leading markets by a wide margin in 2018, look particularly expensive.
While it may be true US non-financial corporations are not facing a big wall of maturing debt over the next couple of years, with many having in recent years issued debt of longer and longer maturities, the inescapable fact remains that balance sheets have been leveraged excessively. As and when the next recession arrives, defaults could be heavy.
The expansion of triple-B rated debt is a particular concern. These bonds, which sit just above the high-yield or speculative market segment, now account for close to half of outstanding US investment grade corporate debt. That raises concerns over a potential lack of liquidity were a wave of downgrades to lead to forced selling by institutional investors.
On the plus side, however, the risk of a recession does not look like an immediate threat. Although the economic cycle appears mature, there is little indication a recession is around the corner. So long as the economy keeps growing most companies should be able to refinance their debt, even as interest rates rise.
Nevertheless, in the meantime, even without a wave of defaults, the new volatility regime we appear to have entered suggests there is scope for credit spreads to widen. Although credit markets have already reacted, this looks to be an opportune moment to either further reduce exposure to, or go short of, the US corporate bond market.
Source all market data: Bloomberg