Source: Deutsche Bank, Bloomberg Finance LP Market Group as of February 12, 2018. The volatility implied spread is based on a Deutsche Bank model consisting of equity and bond volatility in both regions and global foreign exchange (FX volatility). May not be indicative of future results.

Figure One shows the actual HY spread versus the spread implied by a model based on different volatilities. And it makes intuitive sense of course that high yield spreads and volatility should be related in this way – classic corporate finance theory tells us that being long corporate credit is similar to being short a put and, clearly, periods of high volatility will both cause spikes in the VIX (definitionally), and drive put prices higher (hurting short positions).

However, what the Global Markets team noted was that, at the time in early February, when the VIX was signaling panic, high yield spreads were relatively more sanguine. For example, they noted that with a VIX at 30, credit spreads should have been 315 basis points higher than they actually were. Of course, this begs the obvious question – why was high yield looking over at the equity market with a bemused look on its face wondering what all the fuss was about. One possibility, that the Global Markets team noted, was that the spike in the VIX was a short term technical spike that was driven by specific and idiosyncratic events in the markets at that time.

If that’s right, it raises an interesting prospect, that the time to really start worrying about market sell-offs, and volatility spikes, is when high yield credit spreads blow out, and stay there too. The bond markets, it seems, may be harder to spook, but are arguably well worth listening to when they do.

Diversification neither insures a profit or protection against a loss.

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