We and more than a few other folks have recently suggested that no matter how benign you think the outlook is going forward, there’s just simply not much more in the way of compression you’re going to be able to squeeze out of credit.
As a reminder, Bill Gross said the following about HY earlier this month: “I don’t think high-yield spreads have any more to compress.”
If that assessment is correct, shorting credit is a sure thing. Of course no one wants to do it (unless they’re shorting HY ETFs). Here’s how Citi described the situation earlier this year:
Spreads could evidently still compress further under some (optimistic) scenarios, but most portfolios are long to benchmark already and at current levels the potential downside greatly exceeds the potential upside no matter how you look at it. That leaves a glaring asymmetry. Instead, we’d argue the principal concern people have with decompression trades here is that they tend to be negative carry.
When spreads are low, volatility is low and dispersion is low, a few basis points of carry can matter a lot to a fund’s percentile performance against peers. And against the short-term metrics by which performance tends to be measured many will struggle to forego the incremental carry — until a negative trigger becomes immediately obvious.
If that sounds like the very definition of “picking pennies in front of a steamroller,” that’s because it is.
Well along these same lines, BofAML is out on Monday with an interesting look at IG. Specifically, the bank asks the following:
Has the so-called floor for IG risen since 2014? And if it has, does it represent a cheap short at these levels?
In other words, is the “tightest tight” for spreads now higher than it was and have we already reached it?
Read below as BofAML compares credit to volatility by way of a fundamental value analogy where single names are to IG what realized vol is to implied vol.
Via BofAML
Well, that didn’t last very long
Markets were spooked out of their dormancy last week, but it already looks like just a momentary blip. The political drama gripping Washington had been largely overlooked by the market initially. Earnings were strong and there are signs of a healthy pick-up in the economy after a disappointing Q1. In addition, vestiges of the postelection euphoria on policy reform continue to maintain their grip, although the initial level of optimism has been dampened somewhat. News reports about alleged interference in the FBI’s investigations and the appointment of a special counsel finally led to a spike in volatility, a recognition that this could make the policy agenda harder to achieve. The FOMO attitude prevails once again however; VIX and IG for example have already re-traced 70% and 60% of the way back respectively as of Friday’s close.
For the most part the market tends to ignore political theater, unless the economic ramifications are clear and present. The duration and eventual scope of the investigation are as yet largely unknowable. If the last couple of weeks are any guide however, it seems likely that a steady drip of news stories will keep political uncertainty hovering in the background. If these circumstances persist long enough, fatigue will set in and the bar for the market to react, in either direction, gets raised higher.
While the ‘beta’ to political goings-on may peter off over time, there is the risk that the market also starts writing down the probability of the administration’s policy agenda getting accomplished. There is some evidence from loan growth data for Q1 for example, that consumers and businesses may be in wait and see mode before making spending and investment decisions. Continued inaction on their part could eventually start turning economic data in the wrong direction.
If VIX could do it, can IG?
Over the past month it’s been interesting to see that IG spreads seemed to encounter some resistance to breaking below the 62bp level. For context, the post-crisis low in IG was 56bp and even at its tightest spread this month, the index was over 6bp away from that spread (Chart 1). In contrast, equity volatility, which has a strong link to credit spreads, touched record lows this month. For comparison, the 2014 low in VIX was 10.3, a level around which the index has been hovering recently and even closed below on a few days this month. Has the so-called floor for IG risen since 2014? And if it has, does it represent a cheap short at these levels?
Arbitrage relationships
For all the technicals surrounding the VIX index, it is still firmly tied to a fundamental value driven by S&P 500 realised volatility (Chart 2). And SPX has been realizing very little volatility this year — there have been only two days so far this year where the index fell more than 1%, compared to 17 such instances last year through May, 10 in 2015 and 8 in 2014. The index itself has barely been moving, so it’s not surprising that implied volatility is depressed.
For IG, the comparable ‘fundamental’ analogy is the fair-value implied by single-names. Because of liquidity constraints at the single-name level, the arbitrage relationship here may not be as tight as in SPX implied-realised volatility, in that the skew has become unusually large in the past and remained there for a while. And because the index itself is more liquid than singles, it could be argued that it almost always leads single-names i.e. the skew can correct after the index tightens. That said, back in 2014 the index-to-intrinsic spread was close to 0. Over the last week the skew tightened to about -3bp, compared to -4bp to -6bp earlier in the month. So, single-names are catching up with the index, but are still relatively wide. The skew will likely need to correct more for the index to tighten significantly towards its 2014 low.
