• Multi-Strategy Fixed Income
  • Rates
  • Credit

Rising volatility signals trouble for US corporate bonds

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.

4 minute read


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
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
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
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


Related views

Important information


Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.