Another day, another lament about an "eerily still market", comatose volatility, everyone and their hot dog vendor selling vol, and all the other complaints that have become a staple of the financial press which now warns on a daily basis about the threats posed by record low volatility, only this time in credit and this time with a poetic kicker.
Launching with a quote by Dr. Seuss, BofA's junk bond expert Michael Contopoulos writes that "credit implied volatility is at all time lows, skews are flat and implied-realized premium has collapsed." His advice - the same as that from any other non-central bank entity - "time to sell vol is behind us." To wit:
Gray days. Everything is gray. I watch. But nothing moves today. - Dr. Seuss, My many colored days
Still, there is a major foonote: while vol appears "calm on the surface", Contopoulos notes that in the single-name space volatility is "churning" busily underneath. His take:
The market seems almost eerily still. The Fed's tightrope walk, reconciling a rate hike with weak inflation data, did not move credit or equity prices materially.
WTI dipping below $45 barely registered in benchmark index moves.
And geopolitical risk, always in the background these days, has yet to affect markets in any meaningful way.
Every day feels like a gray day.
Realized volatility in credit, both cash and CDX, is within its lowest quartile.
Implied volatility is at all-time lows, implied-to-realized premiums have collapsed and the volatility skew has flattened. Index spreads themselves are a touch away from their post-crisis tights.
But taking one look beneath the smooth surface reveals a far more turbulent picture, and it is here that the risk resides according to Contopoulos, because "as 2014-15 taught us, the 'idiosyncratic' in credit often feeds into the 'systemic', thanks to poor liquidity."
Yet we think index level prices and moves are concealing pockets of name-level volatility. This is to be expected at tight spreads with favorable macro conditions. However, as 2014-15 taught us, the 'idiosyncratic' in credit often feeds into the 'systemic', thanks to poor liquidity. And index valuations leave little room for error here. The persistence of a large negative skew in CDX (index much tighter than single-names), even as the indices approach post-crisis tights, doesn't seem sustainable. Unless some single-names reverse course from recent underperformance, CDX spreads are more likely to be wider rather than tighter over the next month or so.
So it is time to start selling indices? BofA won't commit quite yet - recall Contopoulos got burned - badly - last year when he was short into the relentless junk bond tide, but he does think that the time to at least put hedges on is here.
If not outright index shorts, it is time to start setting hedges. We've often recommended taking advantage of the steep term-structure and hedging by buying 1m ~30delta payers, funded in part by selling 2m or 3m ~20delta payers. This time around, we'd be a little cautious with this strategy, as Aug/Sep may be prone to some event risk with the deadline for extending the debt ceiling coming up and also the potential for some volatility post a summer lull. With the skew in IG essentially flat, we think buying outright 1m payers here looks most attractive e.g. June 65bp payer offered at 5.25c (as of Thu close).
Below Contopoulos explains why he is taking his first, tentative steps to return to the dark side.
Top down calm: Realised volatility in investment grade credit is within its lowest quartile, in both cash bonds and CDX IG. High yield volatility has been even more subdued - 1m bond excess return volatility is at the 18th%-ile using data since 1996, while in CDX it's at the 10th%-ile. Credit option implied volatility, not to be outdone, is at an all-time low (Chart 2).
None of this however seems to have whittled the appetite to sell volatility. The strategy of selling credit volatility, despite lower spreads and lower implied vols, did not strike us as particularly worrying this year, as the implied-to-realised premium remained at reasonable levels compared to its historical range. Over the last couple of weeks however, this has started changing and the gap between the two has shrunk significantly, especially in IG (Chart 3).
And it is not just at-the-money (ATM) vol that is low. The payer skew in CDX is extremely flat (Chart 5 and Chart 6). And receiver volatility in IG has collapsed relative to ATM. With spreads not far from their post-crisis tights, implied volatility at its lows and compressed volatility premiums, we think the time to sell credit volatility is behind us now.
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Bottom-up churning: Low index volatility has been concealing significant moves at the single-name level. Dispersion has been creeping up, as is to be expected at high valuations and overall favorable macro conditions. The rout in Technology stocks this week, albeit short-lived, is a good example. In credit, while indices have uncharacteristically ignored the sell-off in oil, Energy sector names have underperformed significantly (Chart 7).
Single-name volatility goes beyond the Energy sector. In IG, Nordstrom sold off after reports of plans to take it private. Rite Aid widened on news reports that the FTC may not approve its merger with Walgreens. Other Consumer names like Staples, Neiman Marcus and JCP have all been underperforming the indices, as have Hertz and Community Health to name a few. Admittedly, outside the Energy sector, most of the affected names are HY. In fact, the number of names with significant moves wider is high given the index spread (Chart 9). We think this explains the recent underperformance of HY relative to IG (Chart 10), although it is in keeping with the direction we've come to expect i.e. decompression into spread rally and compression into sell-off.
Increased single-name dispersion is bringing the skew in CDX to very negative levels. It is now as wide as it was in February even as the index continues its march lower. In fact, since 23rd May (the most recent peak in oil) IG is 3bp tighter while the fair-value implied by singles is 0.7bp wider. This doesn't seem sustainable; for the index to continue its path lower, some single-name stories will likely have to reverse course. If that doesn't happen, we think CDX is more likely to be wider than tighter over the next month.
While each single-name story is 'idiosyncratic', when they all occur at the same time, they stop being so. In addition, the combination of soft economic data and lack of policy momentum in Washington may induce some jitters over the next couple of months. Finally, there is the possibility of some event risk in Aug/Sep, given the upcoming deadline for extending the debt ceiling. We'd refrain from being too long here and think it is a good time to initiate some hedges.