Is volatility dead? No, sell credit

There are several arguments that one could currently make for why credit markets look unattractive. These include signals that the US economy is in late cycle, the fact that corporate leverage has been increasing (with 2016 setting a record for the amount of global bond issuance), and that US high-yield default rates have risen considerably through 2016, to their highest level since early 2010.

However, while there are many credit market specifics that could contribute to forming an unfavourable view on credit, our fundamental problem with markets is that implied volatility is far too low.

Importantly for bonds, changes in implied volatility are what normally drive credit spreads. It was possible to rationalise implied volatility being artificially low when all the world’s major central banks were extending and expanding quantitative easing (QE), but this is no longer the case.

In a recent blog post, we wrote about our scepticism over the huge reflation consensus narrative in the investment world. We also felt that too much optimism had been priced in regarding Trump’s pro-market/pro-business agenda, while seemingly ignoring the risks and negative aspects of his policies. Markets seemed to ignore the possibility that Trump may not be able to get all of his agenda through as planned.

Indeed, we think that – if anything – global political and economic risks have significantly increased since the autumn. Market pricing of this risk, however, has moved in the opposite direction.

The disconnect between global economic uncertainty and market-implied volatility is most extreme in credit spreads. While the Global EPU Index has risen sharply, credit spreads have actually tightened.

Source: Bloomberg, 01/01/2003 – 31/03/2017. Past performance is not a reliable indicator of future results.

One can see a similar pattern in other measures of risk, such as the VIX Index (the option-implied volatility of options on the S&P 500). This is because credit spreads and equity market volatility are highly correlated. The chart below demonstrates the strong positive correlation between the VIX index and BBB credit spreads. In fact, the VIX Index closed, on Monday, at its lowest level since February 2007. As implied volatility rises, we should also see this drive credit spreads wider.

Source: Bloomberg, 02/01/2004-27/04/2017. Past performance is not a reliable indicator of future results.

Since we wrote our last blog post, we have seen further unwinds of many of the Trump Trades, as investors become increasingly nervous about the US administration. The idea of Trumpflation, however, is alive and well, and investor nervousness has not spread to credit markets – yet.

One factor that has helped to keep credit spreads low is the ultra-accommodative monetary policy from central banks, such as the European Central Bank (ECB). However, the ECB appears to be on a path to reduce its purchases, while the Bank of England has stopped.

Source: Bloomberg, 01/01/2011-07/03/2017. Past performance is not a reliable indicator of future results.

European credit

Our concerns about political and economic uncertainty are global, but our focus is on Europe in particular. Europe bears so much of the upcoming political risk, notably Brexit and upcoming elections (way beyond France). The EU has a massive trade surplus with the US, and is therefore particularly vulnerable to Trump’s policies; this is very consistent with Trump’s anti-EU rhetoric. At the same time, concerns about European banks and Eurozone periphery economies are ongoing.

Banks have benefited from sharp steepening of Eurozone yield curves, but in a risk-off move we believe that core Eurozone government bond yield curves have the potential to flatten from what are now historically steep levels, which should put further pressure on European banks.

The Itraxx Sub Financial index is constructed from the Credit Default Swaps (CDS) of 30 European banks, equally weighted, with 1/3 of them coming from a combination of France, Italy and Spain. The index is highly correlated with periphery spreads, and is therefore we believe the best way to express our views on global uncertainty, political risks, European banks and European periphery risk.

While credit markets have become less worried about the French elections (and Italian politics), peripheral spreads have remained under pressure to widen. We have actually seen the Itraxx Sub Financial tighten year to date. Given that these tighter levels now imply a lower level of risk in the European financial system, buying protection on this CDS index is a relatively cheap and attractive proposition.

Source: Bloomberg, 01/01/2012– 27/04/2017. Past performance is not a reliable indicator of future results.

In a nutshell, the uncertain future path of monetary policy means that it is difficult to specify the catalyst that would cause corporate bonds, as the last ‘Trump Trade’, to start unwinding. However, at this level, any change in implied volatility would certainly drive credit spreads wider. Political factors, financial instability, the ending of QE programs and the materialisation of expectations for monetary tightening could all put pressure on credit spreads to widen.

Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested.

Past performance is not a reliable indicator of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor’s local currency. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or wilful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail.

This is a marketing communication issued by Allianz Global Investors GmbH, www.allianzgi.com, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations. The information contained herein is confidential. The duplication, publication, or transmission of the contents, irrespective of the form, is not permitted.

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