One piece I put recently...
In the previous article we went through some stylized facts inherent in volatility which enjoy a well-documented degree of predictive power. Now we want to go a step further and address the link between volatility and credit markets.
Do you remember the fancy collateralized debt obligation (CDO) during the financial crisis in 2008? Think about volatility (XIV ETNs) as a part of a CDO like structure. The CDO is sliced into tranches, which capture the cash flow of different payments in sequence based on seniority. The lowest trance, the equity tranche, or the first loss piece is our XIV ETNs. So what is next in the capital structure and what we shall be paying attention to? Maybe high yield bonds?
The existing theoretical literature and frameworks uniformly suggests a positive relationship between stock volatility and credit spreads of primarily HY corporate bonds as higher volatility corresponds to a higher probability of default.
However, what we normally see is that credit markets lead: the premiums on HY bonds tend to widen even a year before we see higher equity volatility. This demonstrates again how the central banks distorted some of the traditional risk management frameworks. But maybe this time is the other way around: the normalization of the equity volatility will feed into the credit markets and the credit spreads will move to higher territory. That investors are very sensitive to shifts in the volatility regime is especially pronounced in the HY credit markets. These layers of the credit market react as first to any jitters in the capital markets as recently in equity:
However, many of us could say: yes, we see this but the recent calamity will fade away. But keep in mind: Volatility tends to cluster (meaning that high volatility is likely to be followed by high volatility periods, and vice-versa). In addition, there are several catalysts which could accelerate and be supportive for this channel:
1) The credit spreads are at very tight levels reminiscent of the levels before the financial crisis in 2008 (we saw some pick up recently following the equity volatility outburst)
2) Credit markets have grown considerably since the financial crisis. Low rates and easy liquidity drove a need for yield, which led to significant demand for credit. Spreads compressed, and all-time low yields incentivized companies to issue debt. According to data from Morgan Stanley the US credit market index debt rose by more than 120% (8,000bn US) compared to 2008.
3) Credit quality has deteriorated: There were significant shifts from higher grade rating (AAA to A) to lower grade rating (BBB). Looked at another way, the lower-quality part of the IG market (rated BBB) combined with the HY and loan indices makes more than 60% of total corporate debt today. We are basically at point where we could see a lot of downgrades toward HY sector once we see shift in the credit cycle.
4) The corporate balance sheet leverage has been constantly creeping higher. High levels of leverage on a weighted average basis precede a spread widening. According Société Générale investors should focus on this leverage ratio when considering how (corporate) bond markets will perform in 2018.
5) Normalization of the volatility of treasuries as a result of the unwinding central balance sheets, higher inflation (expectation) and rising interest rates (higher term premium). A key aspect whether this is a short-term technical equity turbulence, which quickly reverses, or the beginning of gradual shift among other asset classes, lies in where rates volatility goes from here. The long-term average for the Move index, the bond market's equivalent of the VIX, is about 96 if we take into account all time series back to the 1980. We already know that volatility is mean reverting…
6) In addition, to point 5) it is very interesting that a large position in mortgage (1.8tn USD) has to be offloaded until 2021 into the market. Mortgages enjoy a prepayment option which is employed when interest rates go down (negative convexity) and their duration lengths when the interest goes up. However, FED does not hedge its exposure with interest swaps and give this option to rest of the market increasing volatility by a change in the interest rate regime. Some market participants even called it the Bernanke straddle as when the FED buys mortgages takes interest rate risk out of the market it reduces the volatility of yields and reduces the risk premium embedded into longer-term interest rates and vice versa. Normally traders and other market participants hedge this by mean of interest rate swaps. In practice, this often means buying duration (betting swap rates will fall) when mortgage rates go down and selling duration (betting swap rates will rise) when mortgage rates go up. So the market could end up in a messy volatility trap similar to the XIV ETNs. Here the market rebalancing increased realised volatility, which pushed up implied volatility and the VIX, and because of that the XIV ETNs imploded. A sudden initial rise in medium- to long-term rates can therefore trigger a self-reinforcing sell-off in treasury yields and related fixed income markets, a convexity event where hedgers collectively attempt to decrease duration risk by selling treasury securities.
7) Positive correlations among asset classes transferring an idiosyncratic risk in on asset class to a macro risk.
8) Low liquidity due to regulation
So there is no surprise as we saw recently heavy outflows from HY market:
We need to remind ourselves some basic fixed income usances: Jason Voss (“A Bond Convexity Primer”) gives a very good example of duration and convexity: convexity is known as the rate of change in change. For convexity to make better sense, he compares it to driving a car. When you are driving a car your speed is the rate of change in the car’s location. Want to change your speed (i.e., the rate of change)? Then you either give the car more gas with the accelerator or press down on the brakes to slow the car down. Speeding up and slowing down are the second derivative. Speeding up means that there is a positive second derivative, while slowing down means that there is a negative second derivative. Related to the bond market, the speed of your car is called duration, while the speeding up/slowing down is known as convexity. The higher the convexity, the more dramatic the change in price given a move in interest rates. Whatever you call it, after a while, if you keep braking a car it stops. After a while, if your bond is experiencing negative convexity, it also slows down/loses value. The harder the acceleration or braking, the greater the change in your speed.
The central banks moved lot of fixed income managers into higher duration in order to be compensated for lower yields. We know that bonds with higher duration are more sensitive to changes in interest rates. As a result investors hold bonds with higher sensitive than they did few years ago. In addition, most of the HY bonds exhibit negative convexity due to their optional features. The increase in duration resulted in larger losses for the bond relative to an equivalent non-callable bond when rates rise and vice versa: when duration declined, resulting in a smaller gain relative to a non-callable bond. The negative convexity of the bond enhanced the downside during a sell-off and limited the upside during a rally. The holder of the bond not only suffered a mark-to-market loss, but has to manage higher duration investment that continues to suffer from negative convexity. So owning negative convexity bonds (HY bonds) is maybe not a good idea in environment of higher volatility and rising interest rates… We might see interesting times in the bond markets.
In the previous article we went through some stylized facts inherent in volatility which enjoy a well-documented degree of predictive power. Now we want to go a step further and address the link between volatility and credit markets.
Do you remember the fancy collateralized debt obligation (CDO) during the financial crisis in 2008? Think about volatility (XIV ETNs) as a part of a CDO like structure. The CDO is sliced into tranches, which capture the cash flow of different payments in sequence based on seniority. The lowest trance, the equity tranche, or the first loss piece is our XIV ETNs. So what is next in the capital structure and what we shall be paying attention to? Maybe high yield bonds?
The existing theoretical literature and frameworks uniformly suggests a positive relationship between stock volatility and credit spreads of primarily HY corporate bonds as higher volatility corresponds to a higher probability of default.
However, what we normally see is that credit markets lead: the premiums on HY bonds tend to widen even a year before we see higher equity volatility. This demonstrates again how the central banks distorted some of the traditional risk management frameworks. But maybe this time is the other way around: the normalization of the equity volatility will feed into the credit markets and the credit spreads will move to higher territory. That investors are very sensitive to shifts in the volatility regime is especially pronounced in the HY credit markets. These layers of the credit market react as first to any jitters in the capital markets as recently in equity:
However, many of us could say: yes, we see this but the recent calamity will fade away. But keep in mind: Volatility tends to cluster (meaning that high volatility is likely to be followed by high volatility periods, and vice-versa). In addition, there are several catalysts which could accelerate and be supportive for this channel:
1) The credit spreads are at very tight levels reminiscent of the levels before the financial crisis in 2008 (we saw some pick up recently following the equity volatility outburst)
2) Credit markets have grown considerably since the financial crisis. Low rates and easy liquidity drove a need for yield, which led to significant demand for credit. Spreads compressed, and all-time low yields incentivized companies to issue debt. According to data from Morgan Stanley the US credit market index debt rose by more than 120% (8,000bn US) compared to 2008.
3) Credit quality has deteriorated: There were significant shifts from higher grade rating (AAA to A) to lower grade rating (BBB). Looked at another way, the lower-quality part of the IG market (rated BBB) combined with the HY and loan indices makes more than 60% of total corporate debt today. We are basically at point where we could see a lot of downgrades toward HY sector once we see shift in the credit cycle.
4) The corporate balance sheet leverage has been constantly creeping higher. High levels of leverage on a weighted average basis precede a spread widening. According Société Générale investors should focus on this leverage ratio when considering how (corporate) bond markets will perform in 2018.
5) Normalization of the volatility of treasuries as a result of the unwinding central balance sheets, higher inflation (expectation) and rising interest rates (higher term premium). A key aspect whether this is a short-term technical equity turbulence, which quickly reverses, or the beginning of gradual shift among other asset classes, lies in where rates volatility goes from here. The long-term average for the Move index, the bond market's equivalent of the VIX, is about 96 if we take into account all time series back to the 1980. We already know that volatility is mean reverting…
6) In addition, to point 5) it is very interesting that a large position in mortgage (1.8tn USD) has to be offloaded until 2021 into the market. Mortgages enjoy a prepayment option which is employed when interest rates go down (negative convexity) and their duration lengths when the interest goes up. However, FED does not hedge its exposure with interest swaps and give this option to rest of the market increasing volatility by a change in the interest rate regime. Some market participants even called it the Bernanke straddle as when the FED buys mortgages takes interest rate risk out of the market it reduces the volatility of yields and reduces the risk premium embedded into longer-term interest rates and vice versa. Normally traders and other market participants hedge this by mean of interest rate swaps. In practice, this often means buying duration (betting swap rates will fall) when mortgage rates go down and selling duration (betting swap rates will rise) when mortgage rates go up. So the market could end up in a messy volatility trap similar to the XIV ETNs. Here the market rebalancing increased realised volatility, which pushed up implied volatility and the VIX, and because of that the XIV ETNs imploded. A sudden initial rise in medium- to long-term rates can therefore trigger a self-reinforcing sell-off in treasury yields and related fixed income markets, a convexity event where hedgers collectively attempt to decrease duration risk by selling treasury securities.
7) Positive correlations among asset classes transferring an idiosyncratic risk in on asset class to a macro risk.
8) Low liquidity due to regulation
So there is no surprise as we saw recently heavy outflows from HY market:
We need to remind ourselves some basic fixed income usances: Jason Voss (“A Bond Convexity Primer”) gives a very good example of duration and convexity: convexity is known as the rate of change in change. For convexity to make better sense, he compares it to driving a car. When you are driving a car your speed is the rate of change in the car’s location. Want to change your speed (i.e., the rate of change)? Then you either give the car more gas with the accelerator or press down on the brakes to slow the car down. Speeding up and slowing down are the second derivative. Speeding up means that there is a positive second derivative, while slowing down means that there is a negative second derivative. Related to the bond market, the speed of your car is called duration, while the speeding up/slowing down is known as convexity. The higher the convexity, the more dramatic the change in price given a move in interest rates. Whatever you call it, after a while, if you keep braking a car it stops. After a while, if your bond is experiencing negative convexity, it also slows down/loses value. The harder the acceleration or braking, the greater the change in your speed.
The central banks moved lot of fixed income managers into higher duration in order to be compensated for lower yields. We know that bonds with higher duration are more sensitive to changes in interest rates. As a result investors hold bonds with higher sensitive than they did few years ago. In addition, most of the HY bonds exhibit negative convexity due to their optional features. The increase in duration resulted in larger losses for the bond relative to an equivalent non-callable bond when rates rise and vice versa: when duration declined, resulting in a smaller gain relative to a non-callable bond. The negative convexity of the bond enhanced the downside during a sell-off and limited the upside during a rally. The holder of the bond not only suffered a mark-to-market loss, but has to manage higher duration investment that continues to suffer from negative convexity. So owning negative convexity bonds (HY bonds) is maybe not a good idea in environment of higher volatility and rising interest rates… We might see interesting times in the bond markets.
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