U.S. High Yield At A Crossroads

by: Evariste Lefeuvre

For many analysts, the VIX has failed to provide an adequate gauge of the ongoing level of risk aversion. Two of the three charts below would confirm that. More precisely, the VIX (I use the 6M-1M slope) provided a good proxy of the level of risk aversion within the stock market as it remains closely linked to the 1-month return.

Yet, the slope of the VIX Futures contract strip failed to track EMBi and US high yield 1-month total returns. This would mean that, in a world characterized by more idiosyncratic risks, the VIX does not provide a strong signal of overall risk aversion, but is limited to reflecting the stock market risk.

If the 1-month total return of the US high yield bond is no longer driven by the slope of the VIX curve, what about the relative (beta adjusted) performance against US Treasuries?

The chart below shows another interesting pattern: in spite of the strong outperformance of US Treasury bonds, the US high yield market failed to significantly outperform the US stock market.

Hence, over the recent weeks, the US high yield market over performed the US stock market but underperformed the US Treasury market, a pattern sufficiently rare to be underlined.

Meanwhile, the relative performance between US junk and IG total return indexes was completely in sync with that of US Treasuries.

Summing up, the intra credit relative performance (US high yield vs. Investment Grade) remained in sync with traditional drivers (US Treasury yields).

On the contrary, on a cross asset basis, junk bonds failed to significantly outperform equity markets even though they distinguished themselves from any EM-crisis related assets: EMBi and CEMBi. This should be a pure country effect, the US being isolated from the ongoing EM crisis so far.

Bottom Line: The disconnect of EMBi and Junk from the slope of the VIX is further proof of the idiosyncratic and not pervasive nature of the so-called "fear index."

The US high yield market presents a relative disconnect from equity and US Treasury related events. As such, the US high yield market failed to outperform equities as much as the recent fall in US Treasury yields would have suggested.

It is easily explained by the historically tight level of high yield spreads. It is not explained by any significant cash/CDS disconnect: even if CDS (HY CDX index) changes did follow more closely the VIX curve over the recent past, the total return of the cash market did not disconnect from the CDS market as much as it did last July (investors were not concerned by a rise in risk aversion, but by the expectation of higher Treasury yields - see chart below).

To me, it mostly highlights the skewed risk-reward of this market this year: higher UST yields if the growth momentum improves and the Fed normalizes, and potential rise in default if the fall in the ISM appears not to be an isolated event (then US growth would be much lower than currently expected).

Therefore, I would clearly lower my exposure on US high yield bonds given that they do not benefit from any decline in US Treasury yields and remain exposed to the risk of a slowdown in the US economy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.