The stock market sees the problems ahead. Bonds don’t. Which one is fair?
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According to BofA Securities, two measures of financial market risk tell conflicting stories about uncertainty in the corporate sector in the United States.
The first is the
Cboe options exchange volatility index,
or the VIX, which reflects the expectations of the future
S&P 500
fluctuations based on option pricing.
The index, known as the fear gauge, was trading around 29 on Thursday, above its long-term average of 20. It climbed Wednesday to close with its eighth consecutive increase. It was the longest streak in a row since the nine days leading up to the 2016 presidential election.
In other words, investors expect volatility in the coming weeks, even as the S&P 500 closed on Wednesday around 4% of its all-time high.
Risk measures in the corporate bond market do not reflect the same concern. The spread between the yields of corporate bonds and T-bills, or the spread between the yields of corporate bonds, has narrowed considerably over the past seven months.
The ICE BofA Corporate Bond index returns 1.3 percentage points more than Treasury bills. According to the Bank of Americas models, the VIX levels imply that the yield spreads of the ICE indices on T-bills should instead be around 1.6 percentage points.
Credit spreads and equity volatility go hand in hand, as they are both measures of business uncertainties. Yet recently we have seen them decouple, wrote Bank of America strategists led by Hans Mikkelsen in an October 22 memo. Strategists say they are in conflict because VIX sends a signal of high uncertainty … to credit.
This disconnection could mean several things. Equity investors may be too nervous about the volatility around the US presidential election, as federal easing continues to support financial markets. Or, as Saba Capital’s Boaz Weinstein argues in an interview with Bloomberg this week, it could mean that vulnerable corporate bonds could sell out in the weeks surrounding the election.
But it is also possible that this discrepancy simply reflects different time frames. The VIX measures expectations of stock market volatility in the coming months, and corporate bond spreads measure the risk of default over the life of the bonds, as the ICE index has a maturity of 12 years.
This means that investors could bet on the long-term stability of the corporate sector in the United States, with some risk of short-term turmoil around the presidential election.
As Bank of America says: but we’re still waiting [investment-grade] credit spreads … tighter at the end of the year, suggesting that credit is the big one in the room with a firm hand for the long haul.
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