Monday 9 July 2012

Guest post - European Credit versus volatility looks increasingly appealing

"The facts will speak for themselves. Credit them or not, but read!"
Ralph Chaplin - American activist.

Back in January 2011, in our credit conversation "A tale of two markets - Credit versus Equities", we indicated the following in relation to credit and the relationship with equity volatility:
"In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.

In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money) equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study."

In continuation of our previous conversation relating to the relationship between equity volatility and credit, please find the recent analysis from our good cross-asset friend pointing to the current relative attractiveness of being long credit and long volatility:
"Long 1 year atm (At the Money) volatility on Equity Indexes versus long credit via short CDS Indexes positions look increasingly appealing on current levels.
Following the Greek Elections and the European Summit, implied volatilities levels on equity indexes have corrected dramatically while other risk measures are clearly not validating any “blue-sky” scenario (Spain/Italian sov spreads, bund yield, credit spreads…). On current relative valuations long credit vs long equity volalitility positions look particularly interesting.
On the credit side you benefit from the relative backing of huge flows from institutional investors hungry for yield, while still enjoying relatively solid balance sheets from a corporate universe that has consistently been rolling over debt maturities.
On the equity side you are paying reasonable volatility levels, almost in line with the recent subdued realized levels with a large upside should any stress materialize in coming months."

Below the Itraxx Crossover 5 year index vs German DAX Index example :
Chart1 – DAX 1 year volatility ATM (At the Money) chart - source Bloomberg:

Chart 2 : Ratio of Itraxx Crossover versus Dax 1year ATM (At the Money) Volatility since early 2011 - source Bloomberg:

Chart 3 : Using a power regression with a very strong R2 (0.80) here is a chart displaying the implied Itraxx Crossover spread versus the current 1year DAX ATM volatility - source Bloomberg:

Nota Bene: Itraxx Crossover in the above charts has not been adjusted for the 6 month roll effect.

Stay tuned!

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