FIXED INCOME STRATEGY

Turning stocks into bonds

Nov 22, 2017

The search for income has driven many investors to credit, as well as to equity strategies with similar characteristics — potentially leading to unintended risks.

Fixed income highlights

  • The risk of loading up on credit and extracting income by selling volatility rises disproportionately as credit spreads narrow and vol falls further. These strategies offer a high probability of small gains with a small (but growing) chance of large losses.
  • Today’s low-volatility regime could last a long time – especially against a backdrop of economic stability. Reaching for yield through credit and selling options can be self-reinforcing, driving volatility lower on the way down, but exacerbating any reversals on the way up.
  • The economic backdrop is supportive of credit but we prefer to take risk in equities. Within credit we advocate an up-in-quality stance. And we see interest rate normalization by the Federal Reserve gradually restoring the attractiveness of lower-risk fixed income sectors, reducing investors’ temptation to stretch for yield.

Snapshot

Today’s tight credit spreads reflect low levels of market volatility. Credit spreads historically have shown a close relationship with the VIX gauge of U.S. equity market implied volatility. See the Joined at the hip chart below. This is no coincidence: The credit and equity markets are intimately related. To understand why consider the payoff profile of corporate debt: In the best scenarios you get your money back and under the worst (the issuer defaults) you do not. That return profile is equivalent to bondholders having sold a put option on the value of the firm. Demand for liquidity also tends to decline in low-volatility environments, another factor behind the relationship between credit spreads and volatility.

Low-volatility regimes tend to persist, and today's low-vol environment benefits from strong economic support. Yet today's realized levels of volatility stand at historically low levels – even for a low-vol regime. This is true across markets. Such calm may mask vulnerabilities; the concentration of income-seeking strategies and their potential risks are worth keeping tabs on.

U.S. credit spreads versus implied volatility
Jeffrey Rosenberg
Chief Fixed Income Strategist
Jeffrey Rosenberg, CFA, Managing Director, is BlackRock's Chief Fixed Income Strategist and a member of the BlackRock Investment Institute. His responsibilities ...