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.

 

Chart: U.S. credit spreads versus implied volatility
Jeffrey Rosenberg
Chief Fixed Income Strategist
Jeffrey Rosenberg, Managing Director, is BlackRock's Chief Fixed Income Strategist with responsibilities in developing BlackRock's strategic and tactical views.