It’s happening – the VIX volatility index has finally dropped into the teens and is following the high yield spread downward (Chart 1). We have noted in past articles that this pattern is quite unusual – usually in a recovering market the VIX and high yield spread fall roughly in tandem. We have been expecting the VIX to fall – although we acknowledge the more elevated level of VIX since the election could have also been implying that the spread rally in high yield was overdone.
Looking forward we expect the VIX will continue to gradually fall. A combination of vaccines, a reopening economy, and hefty fiscal / monetary support make it unlikely that the economy is going to hit an air pocket any time soon.
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Summary
- The VIX volatility index is finally dropping into the teens, signalling potentially more tightening of high yield spreads from already decade-long tights.
- Moody’s trailing 12-month default rate is now 7.5%, down from a recent high of 8.9% last summer. But the more recent underlying default rate is now about 2%. We anticipate it will remain in the 2%-3% range for the foreseeable future, which will further support the high yield market.
- Over time and especially during recoveries high yield has outperformed investment grade, but almost entirely due to carry or interest income.
Market Implications
- We recommend investors looking primarily for yield in the current low interest rate environment focus on high yield. Investors looking for higher total returns should find better opportunities in equities.
- Investors can get exposure to high yield through the HYG and JNK ETFs.
It’s happening – the VIX volatility index has finally dropped into the teens and is following the high yield spread downward (Chart 1). We have noted in past articles that this pattern is quite unusual – usually in a recovering market the VIX and high yield spread fall roughly in tandem. We have been expecting the VIX to fall – although we acknowledge the more elevated level of VIX since the election could have also been implying that the spread rally in high yield was overdone.
Looking forward we expect the VIX will continue to gradually fall. A combination of vaccines, a reopening economy, and hefty fiscal / monetary support make it unlikely that the economy is going to hit an air pocket any time soon.
Underlying Default Rate is Now 2%
This will be supportive of continuing if gradual tightening of high yield spreads. The high yield market is also benefiting from declining default rates. Moody’s recently announced that the twelve-month trailing default rate fell from 7.5% in February to 7.5% in March, and anticipates that it will fall to 4.1% by 4Q 2021.
We think that could be high – the annualized default rate over the past three months has been only 2%. Actually default rates tend to hit that level when the VIX drops to 10%-12%. If defaults remain low as we expect that is another reason to anticipate further declines in the VIX.
As an aside, equities tend to perform well as the VIX falls, but is more mixed when the VIX is at very low levels (Chart 2). During 2004 – 2007 the S&P 500 price return averaged an unspectacular 7.5%. But over the past decade, price returns during periods of very low VIX were in the 15-20% range.
We Favour High Yield but With Some Caveats
We have been supporters of corporate credit – particularly high yield – since last summer, and continue to be so. As Chart 3a shows, over longer horizons, and during recovery periods high yield has handily outperformed investment grade credit. (We represent IG and HY with the LQD and HYG ETFs, respectively).
That said, in fairness couple of cautionary notes are in order. First, high yield returns are volatile during recessions, on expectations (and often realizations) of rising defaults. There will come a time when investors need to reduce or hedge high yield positions or be prepared to take the long view.
Second, high yield returns consist almost entirely of carry, or interest income. Over the past decade, the price return on high yield has been negligible (Chart 3b). Investment grade has done a bit better, gaining about 20% as the 10-year Treasury yield fell some 300 basis points. This is because high yield bond maturities tend to be about five years, and are callable. As interest rates fall, high yield bonds get called and replaced with lower coupon bonds at par. Investment grade bonds are longer duration and typically not callable so they remain outstanding longer and prices can benefit from falling rates.
In any case, bonds eventually mature and as they do their prices converge to par, limiting potential gains (and losses) from price changes.
Our point here is that high yield is attractive for investors looking for current income and carry. Investors looking to maximize return potential will find far better opportunities in equities.
Investors not in a position to buy individual corporate bonds can invest in a broad investment grade portfolio through the LQD ETF, or in high yield through the HYG or JNK ETFs.
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)