By Rob Bush, DWS
It’s obvious when you think about it. The number of companies that have their shares included as part of the S&P 500, and their bonds included as part of the high yield universe, is pretty small. I made it just 46 names. And of course it makes sense that, as some of the largest and most well established companies in the US, the components of the S&P are unlikely to be those same firms that achieve mere junk ratings on their debt issuance.
And yet for something so obvious, it doesn’t seem, at least to us, to have been that well discussed. The industry often talks about the equity-like nature of the high yield bond universe. And it often talks about the low correlation between high yield bonds and stocks (around 0.42 if you use two years of daily returns) but, now that we know that there are less than 10% of companies in the S&P that are also in one of the major high yield exchange traded funds (ETFs) (HYLB, one of our funds that tracks the Solactive USD High Yield Corporates Total Market Index), perhaps the real question is, why is the correlation so high? After all, we are talking about two universes with very low overlaps.
Of course it’s always hard to tease out rationales for observed correlations. The numbers are simply what the numbers are, and applying a rationale to correlation runs the risk of spuriously inventing a story where none exists. That said, let me immediately run afoul of that risk by suggesting that to the extent an investor moves away from the blue chip nature of the S&P 500 by shifting to smaller, less credit-worthy companies, they also move higher up the capital structure by switching from equities to bonds. However, rationalizing the correlation aside, the main point of interest from all this is simply that, as well as diversifying across asset class when you add corporate debt to an equity portfolio, critically, it’s also a very different universe of companies that investors are gaining exposure to. That fact in isolation surely has to be a good thing.
Causations – How Volatility drives Credit Spreads
So much for that facet of High Yield, let me switch direction now and discuss a fascinating feature of high yield that our Global Markets team discussed shortly after the early February spike in the Volatility Index (VIX). They noted that there has been a historically tight relationship between volatility (equity, bond, and foreign exchange (FX)), and credit spreads.
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.