Nearly six years into the Federal Reserve's (Fed) unprecedented experiment in unconventional monetary policy, nearly every asset class is starting to look pricey.
With cash paying nothing and long-dated bonds barely keeping up with inflation, investors have bid up risky assets from high yield debt to frontier market equities in search of a decent return. In the process, they have left few bargains behind. However, there is one asset class that still looks cheap: volatility. BlackRock and other market watchers have increasingly taken the view in recent years that volatility is an asset class, accessible through funds that track volatility indices and other strategies, that can potentially help reduce portfolio risk and increase returns.
Last week, U.S. equity market volatility, as measured by the VIX Index, hit 10.34, the lowest level since early 2007 and roughly half the long-term average. A similar pattern of low volatility is visible across asset classes and geographies.
Why is volatility so low? The simple answer is that financial market volatility is mostly driven by the credit cycle. When monetary conditions are loose – meaning credit is both available and cheap – market volatility tends to be lower. This relationship is evident when you compare equity market volatility with a proxy for credit market conditions, such as high yield spreads. In the past, the correlation between high yield spreads and equity market volatility has been roughly 80%.
Today, short-term interest rates are still stuck at zero, real short-term rates are negative and companies are flush with cash. In other words, credit conditions are about as easy as they get, a fact reflected in very tight high yield spreads, currently at a 7-year low of around 325 basis points. With credit conditions this easy, you would expect a low volatility regime.
That said, I believe there is a big difference between where volatility should be and where it is today. Even after adjusting for unusually tight credit spreads, volatility should be in the mid-teens, not scraping close to single digits. At today’s levels, volatility is in the bottom 1% of volatility levels going back to 1990. In other words, volatility looks too low even after accounting for a very benign credit environment. This is particularly true considering that investors are ignoring rising geopolitical risk, including recent events in Iraq that have the potential to lead to a nasty spike in oil prices.
The bottom line for investors is that in a world of few bargains, volatility does appear to be the one relatively cheap asset class. And while a continuation of zero interest rates and cash-flush companies will most likely keep volatility below its long-term average for the foreseeable future, it will take a lot of good luck to keep volatility as low as it currently is. This suggests that investors looking to potentially help protect portfolio performance if market volatility suddenly rises in the case of an unexpected correction may want to consider buying volatility.
Sources: BlackRock, Bloomberg