Monday, January 23, 2012

Interpreting the divergence of HY spreads and VIX

The following chart shows the average high yield bond spread (as measured by the JPMorgan HY index) vs. VIX. The divergence seems to indicate that credit is cheap (wide) relative to implied vols.

HY Index spread (STW) vs. VIX
But if the HY market really caught up to VIX, what would these bonds look like?  The answer is that with the 5-year treasuries yielding 0.92%, HY bonds would have an absolute yield of about 6.3% (540bp +92bp).  Even in this low rate environment investors may have a tough time buying non-investment grade bonds at 6.3% yield.  In fact 6.7% has been the floor on absolute yield in the HY market historically, no matter what the spread was.  The yield touched this "floor" level in the low rates environment / boom period of 2005 and again in the first half of 2011 during the euphoria of QE2.  

Absolute yield (YTW) for the JPM HY Index (Bloomberg)
Therefore as spreads continue to tighten, investors will start looking more at absolute yields on HY bonds, potentially putting a floor on these yield levels.  And until treasury yields rise substantially, we may be finding a floor on HY spreads as well.

As far as VIX is concerned, the recent drop definitely looks overdone relative to other risk indicators. This suggests that if the deviation between HY spreads and VIX begins to recede, the next leg of the convergence will be more from rising VIX levels than significant tightening in spreads.
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