European High Yield Looking Vulnerable to Market Turn: Analysis

  • Collapse in volatility has driven credit spread tightening
  • European HY may be asset class most exposed to vol correction

Investors lured to European high-yield debt by brightening growth prospects may be taking on the very assets most likely to be headed for a lurch downwards, writes strategist Simon Ballard.

Volatility has dropped over the past month, spurring investors to seek out riskier assets such as high-yield bonds. Any resurgence in instability over the coming weeks could quickly undermine the buoyancy of corporate credit and several potential triggers are now looming, such as rising geopolitical risks and the possibility of further global cyber attacks.

Studying the correlation between volatility measures and U.S. and European credit indexes shows a rise in volatility may be felt most acutely in European high yield.

Analyzing Bloomberg data since Jan. 1 2016, the correlation between the V1X gauge of implied European credit market volatility and the European high yield index, is 0.86. In comparison, the correlation with European high-grade credit in 0.75. In the U.S. a correlation analysis of both high grade and high yield indexes versus the VIX index, yields results of 0.78 for both.

Volatility has fallen sharply in the U.S. and in Europe since mid-April. Europe’s V1X has retreated from 22.47 on April 18 to 12.25 as of May 16, while the U.S. VIX index has fallen to 10.39 from 15.96 on April 13. These moves have helped to buoy risk appetite and drive a grind tighter in credit spreads.

There could now be a number of potential triggers for volatility to surge again, including the recent malware attack on computer systems around the globe, which could re-emerge. as well as any further surprises surrounding the new U.S. president. Any increased risk of military action on the Korean peninsula may well send volatility sharply higher.

While the trigger is unclear, what’s obvious is that volatility will eventually have to climb from near multi-year lows. When it does, those credit investors likely to feel the greatest impact may be the holders of European high-yield bonds.

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