Photographer: Simon Dawson/Bloomberg

Credit Markets Were Much Less Prepared for Brexit Than Stocks

Almost no change in volatility expectations ahead of the historic referendum.

Have credit investors become so inured to years of cheap money and central bank bond buying that they simply sleepwalked into one of the biggest risks to financial markets in years? 

The credit markets shrugged off Britain's referendum on European Union membership, according to Bank of America Corp. analysts led by Michael Contopoulos. That was not a smart move given that the cost of insuring corporate bonds against default—a key measure of credit risk—rose the most since 2008 on Friday and remained elevated on Monday.

"The risk was there, the credit markets refused to price it, and now we have to face reality: a potential unraveling of the fabric of the European Union and likely more 'referendums,' a possible recession in the U.K., a decrease in business confidence and spending globally, and a decline in risk assets that have gotten way ahead of fundamentals."

Source: Bloomberg

Credit markets appear particularly somnolent when compared with stocks. Two weeks before the referendum, the equity option market priced in a 1.2 percent move in the Standard & Poor's 500 Index, increasing that to a 1.7 percent move during the week of the vote. Meanwhile, volatility was virtually unchanged in the credit option market, meaning credit investors weren't "viewing the vote as a meaningful event," said the Bank of America analysts.

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How credit markets could be so blasé is a function of easy-money central bank policies since the financial crisis giving investors a false sense of security.

As the Bank of America analysts noted: "We had been arguing at length for some weeks that credit markets were poorly reflecting the risk of an EU exit, in part because the [European Central Bank's] Corporate Sector Purchase Programme had been responsible for a big lurch tighter in non-financial bond spreads."

With possible additional measures from the Bank of England potentially including bond purchases, it remains to be seen whether the credit markets will be in for a rude awakening.

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