Investor psychology may play a role here as well. If equities have been outperforming, FOMO (fear of missing out) might encourage investors to get on board stocks even as they offboard from underperforming high-yield bonds.
Figure 8: Credit Spreads Began to Widen Three Months Before the October 2007 Peak.
Options offer another explanation. If the cost of options rises, this could potentially send stocks higher and corporate bonds lower. After all, equities are akin to call options on the value of a corporation with a strike price of zero and no set expiry. Essentially, shareholders’ equity is everything that’s left after a corporation has settled all its other liabilities. By contrast, a corporate bond’s payoff is akin to that of a US Treasury + a short-put option on the value of the corporation. If all goes well, and the company makes good on its debts, investors collect their coupons and get the principal reimbursed. If the firm defaults, however, investors are left on the hook for the losses.
Since equities often outperform credit at the end of bull markets, this makes hedging high-yield bonds with equity index futures a risky and uncertain prospect. However, when the equity bear market comes, high-yield debt and stocks often plunge together, but getting the timing right is everything.
Bottom Line
• Flat yield curves and tight but widening spreads make high-yield bonds look unattractive.
Source: Bloomberg Professional (SPX and LF98OAS)
• Equities often outperform high-yield bonds in the late stages of economic recoveries.
Figure 9: Credit Spreads Hit their Lowest Point of the Current Cycle (so far) on October 1, 2018.
• Correlations between high-yield bonds and stocks are at record highs.
• Hedging high-yield exposures with equity index futures is often treacherous in the late stages of bull markets.
Erik Norland E:
erik.norland@
cmegroup.com
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Source: Bloomberg Professional (SPX and LF98OAS)
27 | ADMISI - The Ghost In The Machine | September/October 2019
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