I was chatting with an acquaintance the other day about the resilience of credit in the face of multiple political land mines that, under normal circumstances, would have caused spreads on IG and HY to widen materially.
[What? Isn’t that something you talk to your friends about?]
We both agreed that while suppressed equity vol. grabs all the headlines, it is in fact credit’s Teflon performance that wins the John Gotti prize for “most bulletproof asset class.”
Indeed, if you would have correctly predicted every political outcome over the past 12 months and traded accordingly in credit, you would have been wrong every time.
Needless to say, a lot of that has to do with QE. Most notably, the resilience of € credit in the face of all manner of political turmoil can be directly attributed to the overwhelming impact of CSPP.
But again, it isn’t just in Europe. If you want to get a kind of 30,000 foot view of things, look no further than Deutsche Bank’s snapshot of spread ranges as presented in a piece out earlier this year amusingly called “The Most Boring Year Ever!”
“While volatility is depressed across the board, credit volatility seems particularly low; compared to history as well as relative to other assets,” BofAML writes, in a great note out on Thursday.
And while “a low spread regime is usually accompanied by low volatility, similar to the relationship between high equity valuations and stock vol,” the bank reminds you that “implied volatility for CDX over the last year has touched new lows even though spreads themselves have struggled to reach their post-crisis tights.”
Have a look:
What’s particularly interesting here is the divergence between VVIX (equity vol of vol) and IG implied vol.
“This state of affairs can be attributed to the high realized vol of VIX,” BofAML writes, adding that “the frequent occurrence of sharp, short-lived shocks justifies a high vol of vol, but we are yet to see such behavior in credit spreads.”
So why is credit so complacent? Well again, part of it is central bank liquidity flow compressing spreads either directly (in € credit via CSPP) or indirectly by encouraging carry trades and driving people into corporate credit in search of yield.
But beyond that, there are two simple explanations. First, realized vol. is low. Here’s BofAML again:
Implied volatility is low because realised volatility is low. Not only is realised volatility for CDX near all-time lows, but it has remained that way for a while now. CDX IG has been realising less than 30% (annualised daily spread) volatility for a little over 6m now, longer than similar stretches in 2014 and 2015 (Chart 13). The effect of such persistently low volatility is that it forces buyers of vol to throw in the towel while emboldening more people to sell vol.
Right. And you can see how there’s a circularity here between vol. and central bank liquidity. That latter bolded passage brings us to what BofAML calls “the evident reason” – namely that there are “more sellers than buyers“:
CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool. While some may choose to hedge using the underlying index, the practice isn’t prevalent among a majority of money managers. Among those who do employ derivatives, the bias has been towards selling protection or selling volatility as a means to park incoming funds while ramping up the portfolio or simply to generate carry/premium. This is particularly true in CDX IG, where for several years now there has been a large non-dealer long base in the index.
There’s more to it than that, but leaving it there helps to ensure the overall message isn’t lost. There are simply more vol. sellers than buyers and that, along with central bank liquidity flow, creates a self-feeding loop. Some might call it: “encouraging bad behavior” or, “creating a one-way market.”
Perhaps the best way to sum it up is just to reiterate what we’ve said before: if equity markets are asleep at the wheel, credit is passed out with its head in the toilet…