Credit Dislocated, Again

We have discussed the dynamics of the credit-equity-vol relationship for many months in the hope that it broadens investment horizons and opens traders' eyes to a bigger picture of global risk appetite. Following (and understanding) the debt-equity relationship has proved, in general, a very useful instrument in an investor's toolkit and Barclay's Capital this week points to just how dislocated European credits are relative to stocks (having underperformed) and while we may not be quite as exuberant as them in the call to add credit exposure here (as we see more structural than cyclical concerns ahead), we cannot argue that on a relative-value basis, arguments for significant re-allocation from bonds to stocks simply do not make sense (from both valuation and risk perspectives) - no matter how many times Pisani tells us so.


From Barclay's Capital: European Credit On Deck:

Credit strongly underperformed equities over the past week, as the  market struggled to follow the equity rally sparked by weekend rumors about potential new sweeping initiatives to contain the sovereign crisis in Europe. While the Eurostoxx 50 has gained almost 9% since last Friday’s close, iTraxx Main is only 4bp tighter – well below the tightening expected given the recent relationship between the two indices (Figure 1). We do not see a fundamental reason for this disconnect and expect some normalization in the near term.


From a historical perspective, the current underperformance is in line with a general theme of credit underperforming equities in periods of elevated market volatility. To illustrate this effect, in Figure 2 we show the rolling average of 3-month z-scores from CDS-equity regressions for constituents of the iTraxx Main S15. Average z-score measures the extent to which current CDS spreads deviate on average  from levels implied by equity prices.


A positive value indicates that credit is trading wide relative to what the equity performance would imply (and vice versa). Over the past four years, spikes in market volatility, as measured by the VSTOXX, have tended to coincide with jumps in the average z-score, highlighting credit market’s unusually strong negative sensitivity to volatility. The most prominent of such instances include:

  • August 2007 – the beginning of the financial crisis;
  • Late 2008 – the Lehman collapse;
  • May 2010 – the first Greek bailout.

Conversely, periods of credit outperformance  have been typically accompanied by low or falling volatility. In other words, since 2007, credit has led equity markets in any downturn, even as the relationship has normalized over longer periods of time.


When broken down to the sectoral level, its  interesting to note that the recent credit underperformance has been consistent across non-financial sectors, with financials being the only sector in which CDS, on average, are trading in line with stocks. Given the close connection between sovereign solvency and bank impairments, it is not surprising that the financial sector has shown a stronger linkage in performance across asset classes. Nonetheless, the significant underperformance of all other sectors relative to equities leads us to argue that credit is poised for outperformance whichever direction the market turns from here. If the rally continues, then on a beta-adjusted basis credit has a long way to go to catch up with equities, while if market softness continues, credit widening should be limited by the fact that it is not very far from the recent (and all-time) wides at the index level.