Global Credit Strategy: Rising Risks to the Credit Market in 1H2018

Credit Analyst, BondAdviser

Jack Pobjoy

Credit Analyst

Australian bonds & fixed income research

BondAdviser

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Thematic (Sector/Industry)

Australia & united states / Thematic (Sector/Industry)

<p>Last month, global equity markets experienced a severe, but transient, sell-off which originated in the US following better than expected wage inflation data.  While this is generally an indication of a strengthening underlying economy, equity investors were spooked by the idea that the era of easy money was coming to an end.  This complacency and comfort had become apparent in the Volatility Index (VIX) compiled by the Chicago Board of Exchange (CBOE). The VIX had progressively declined to pre-GFC lows and due to the historical (and mathematical) positive skew of the VIX (Figure 1), an increasing risk environment occurs much faster than a declining risk environment.</p><p>During the extreme risk-off event, the VIX finished at a market-close high of ~40 but reached as high as ~51 intra-day.  To put this in some perspective, the closing value of the VIX has exceeded 40 just 2.5% of the time over the past 20 years.</p><p><strong>Figure 1. CBOE Volatility Index (VIX) – 20 Year Probability Distribution</strong></p><figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/047/784/original/vix.png?1521589450" class="editor-image img-responsive" data-smartkarma-image-id="47784"></figure><div style="text-align: left;" class="content-caption">Source: BondAdviser, Bloomberg</div><p>Credit spreads are another common forward-looking metric and attempt to capture the probability of default.  This market-implied default measure is connected to equity volatility as information contained in a company’s stock price and balance sheet is used as a foundation of many structural credit models such as Moody’s KMV.  Due to this link regarding expectations, credit spreads have exhibited a notable correlation to the VIX over time (Figure 2) and more so for high-beta credit encapsulated by the US high-yield market. However, despite this correlation, this was not a contagious risk event. </p><p><strong>Figure 2. US Credit Spreads versus CBOE Volatility Index (VIX)</strong></p><figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/047/785/original/vix2.png?1521589580" class="editor-image img-responsive" data-smartkarma-image-id="47785"></figure><div style="text-align: left;" class="content-caption">Source: BondAdviser, Bloomberg</div><p>While US credit spreads widened in the wake of the volatility spike, it was nowhere near the same magnitude as the decline in major equity indices and consequential VIX movement.  This suggests the bond market was not convinced this was an inflection point in the current credit cycle.  This divergence was even more prominent in the Australian market where corporate credit spreads held tight despite the turbulent global conditions (Figure 3).</p><p><strong>Figure 3. US v Australia: Equity and Credit (IG) Performance 2018 YTD</strong></p><figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/047/787/original/vix3.png?1521590396" class="editor-image img-responsive" data-smartkarma-image-id="47787"></figure><div style="text-align: left;" class="content-caption">Source: BondAdviser, Bloomberg</div><p>Overall, a shift in the economic cycle should be based on fundamental changes.  This is a difficult element to capture quantitatively on a forward-looking basis but given that the VIX spike and equities sell-off was arguably exaggerated by volatility-related Exchange Traded-Funds, it is very questionable whether the index is an accurate indicator of fundamentals. For this reason, we prefer the use of credit spreads and/or interest rate differentials in determining where we are located in the broader cycle. We will explore this notion in regards to history.</p>

Last month, global equity markets experienced a severe, but transient, sell-off which originated in the US following better than expected wage inflation data.  While this is generally an indication of a strengthening underlying economy, equity investors were spooked by the idea that the era of easy money was coming to an end.  This complacency and comfort had become apparent in the Volatility Index (VIX) compiled by the Chicago Board of Exchange (CBOE). The VIX had progressively declined to pre-GFC lows and due to the historical (and mathematical) positive skew of the VIX (Figure 1), an increasing risk environment occurs much faster than a declining risk environment.During the extreme risk-off event, the VIX finished at a market-close high of ~40 but reached as high as ~51 intra-day.  To put this in some perspective, the closing value of the VIX has exceeded 40 just 2.5% of the time over the past 20 years.Figure 1. CBOE Volatility Index (VIX) – 20 Year Probability DistributionSource: BondAdviser, BloombergCredit spreads are another common forward-looking metric and attempt to capture the probability of default.  This market-implied default measure is connected to equity volatility as information contained in a company’s stock price and balance sheet is used as a foundation of many structural credit models such as Moody’s KMV.  Due to this link regarding expectations, credit spreads have exhibited a notable correlation to the VIX over time (Figure 2) and more so for high-beta credit encapsulated by the US high-yield market. However, despite this correlation, this was not a contagious risk event. Figure 2. US Credit Spreads versus CBOE Volatility Index (VIX)Source: BondAdviser, BloombergWhile US credit spreads widened in the wake of the volatility spike, it was nowhere near the same magnitude as the decline in major equity indices and consequential VIX movement.  This suggests the bond market was not convinced this was an inflection point in the current credit cycle.  This divergence was even more prominent in the Australian market where corporate credit spreads held tight despite the turbulent global conditions (Figure 3).Figure 3. US v Australia: Equity and Credit (IG) Performance 2018 YTDSource: BondAdviser, BloombergOverall, a shift in the economic cycle should be based on fundamental changes.  This is a difficult element to capture quantitatively on a forward-looking basis but given that the VIX spike and equities sell-off was arguably exaggerated by volatility-related Exchange Traded-Funds, it is very questionable whether the index is an accurate indicator of fundamentals. For this reason, we prefer the use of credit spreads and/or interest rate differentials in determining where we are located in the broader cycle. We will explore this notion in regards to history.

Australian Credit: Looking Backwards to Move Forwards