Volatility and its little sister, the credit market, usually move in parallel and any deviation from their normal relationship offers rare opportunities to invest
Volatility and Credit Risk
There’s an intuitive link between equity volatility and corporate credit risk: higher volatility generally indicates a turbulent market, which would naturally lead us to expect higher default risk on outstanding debt. This relationship is also affirmed if one considers that the most well-known credit risk model, the Merton model, takes into account both a company’s stock price and its volatility. At approximately 75%, data also suggest that the correlation between equity volatility and corporate credit spreads is among the highest among all investment asset classes. The chart below illustrates how the VIX index and the 5yr Investment Grade CDX Index move similarly and perform likewise.
The most important question for our investors is whether this observation can make money, or at least enhance our client portfolio's risk-adjusted returns, either through capital appreciation, or some diversification or risk mitigation. Does the volatility index VIX lead the credit index CDX, or is it the other way around, or do they move in perfect tandem? By running econometrics tests (Dickey-Fuller) we find that the VIX index and the 5-year High-Yield North America CDX Index are indeed cointegrated. This means that not only they are correlated but also that they cannot deviate from equilibrium in the long term. Their relation -- the ratio CDX: VIX -- does not trend. But is it that one acts as the driver and the other follows or is it that they both have equal probabilities to variably act first for some reason?
VECM relationship with KM CUBE
There are a couple or three popular common factor metrics that are used to investigate the mechanics of such price discovery, but they all begin by the estimation of what is called a Vector Error Correction Model (VECM). Interestingly, VECM data shows that the VIX index does not react significantly to an equilibrium error of its ratio with the CDX, whereas the CDX index indeed does. In plain English, this means that the VIX dominates CDX in terms of price discovery. To make it even simpler, if we are not in a regular equilibrium environment, then it is the credit derivatives market that usually does the adjustment, not the volatility derivatives market.
The chart below shows how CDX and the front month VIX future contract behaved during the last ten years. We see that despite their relationship printing at the lowest level since the March 2020 coronavirus crisis, it is actually now only reverting to its long-term average of the past years, and it currently really sits on the mean of that time period. At KM Cube we have been systematically following this relationship between CDX and the VIX since the firm was founded, and our system sporadically signals some pair-trade which has consistently provided above-average returns – albeit infrequent. One cannot make a living out of waiting for CDX to diverge from the VIX. Because over-the-counter derivatives such as the CDX index are not investable for our retail clientele nor the Global Navigator fund, what we are actually tracking is the VIX relation to the HYGH ETF instead -- which is a corporate bond ETF that neutralizes interest rate risk, hence remaining only with the US High-Yield credit risk.
That ratio of volatility
Credit risk last night signaled a trading opportunity. The density curve of their ratio closed above 90%, while at the same time the relevant Z-score closed above 2 standard deviations. (see graphs above).
If the VECM model is correct, one might expect it is more probable that corporate bonds shall follow equities lower. This has occurred both during the coronavirus crisis and during the June 2022 market correction. In actuality, it is not proposed that one should assume such a one-sided risk. If there truly is some trading opportunity to harvest here, then it is a relative-value pair trade where investors sell the HYGH exchange-traded fund and simultaneously sell VIX futures (or VXX?). If anyone is interested to dive deeper into the mechanics of such a trade, we would also take into consideration the weightings between the two legs, because one dollar invested in HYGH does not equal one dollar invested in VIX futures. There are some volatility-related weights we should attribute, but that’s perhaps too technical for here and we remain at your disposal should you wish to discuss this further.
Author: John Couletsis