Higher Volatility Means Wider Credit Spreads

 

by Rom Badilla, CFA

May 4, 2010

“The road to hell is paved with positive carry.” –Bond market adage

The S&P 500 is down by more than 2 percent and the Volatility Index aka VIX is shooting up by more than 23 percent percent to the mid-20′s level.  Credit spreads typically move in lock-step with Volatility as uncertainty rattles corporate bond market investors.

VIX and Credit Spreads 10-Year History

The correlation between volatility and spreads is very high as illustrated in the chart.  The correlation over this time frame is 0.88 for Investment Grade bonds and 0.93 for High Yield bonds (A 1.00 correlation means the two move in lock-step in the same direction while a -1.00 means they move in opposite directions.  A correlation of 0.00 means that they are practically unrelated.)

Interestingly in early 2008, credit spreads widened more than what the relationship implied at that time.  In March 2008, spreads spiked (by almost 54 basis points to 852) while equity volatility remained the same (VIX stayed in the mid-20′s).  As we all know shortly after, Lehman brothers collapsed and equities started its tumble on its way to a Bear market lasting until March 2009. 

Credit spreads can sometimes signal a bumpy road and market pressure well before the equity markets. It doesn’t occur all the time but when it does, it certainly requires notice. Going forward, divergence in the relationship is something to monitor to determine if this sell off in equities is short-term in nature or the beginning of another journey down a bear market road. Stay tuned.

 
 
 

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