Looking for Credit Sentiment in the Equity Derivatives Market

A recent Bloomberg news story, “Sum of All U.S. Credit Fears Sinks to Almost Five-Year Low,” described results of a survey of credit concerns with a graphic (Figure 1) depicting a recent decline and shift to the lowest survey level seen since mid-2014.

Figure 1 - Credit Investor Survey

Interestingly, the pattern of the sentiment series is also reflected in a broad-based synthetic spread risk measure that Hanweck generates from the equity derivatives market--Issuer Volatility Risk (IVR). IVR generates a probability of default based wholly upon equity derivatives data and is computed for stocks with listed in options. The index IVR measure displayed here for Russell 1000 is computed as a weighted aggregate of individual risk measures for all stocks in the Russell 1000 with listed options.

Figure 2 compares the Hanweck Issuer Volatility Risk™ (IVR) measure calculated across the constituents of the Russell 1000 compared to investment grade credit default swap index, the CDX.NA.IG series, both spanning most of the history covered in the Investor Survey data (2012-2019). The CDX North American Investment Grade comprises 125 credits and is a standard reference for an average credit spread as expressed across the CDS market. We include it here to provide another empirical measure of credit spread.

The CDX series shows the drop off from the spike of Q4 2018 but otherwise does not show a distinct 5-year low. In fact, there are multiple instances from 2017, back to early 2014, where the spread levels seem to have hit the same low trough—all lower spreads than more recent levels in Q1 2019. Issuer Volatility Risk measured across the broad index reveals a reduction in perceived risk that is notable in two ways.

First, the IVR level at .10 (an index value related to the probability of default) has reached a low that aside from a spike down in Q3-2018, is the lowest since the same trough period of 2014 found in the Investor Survey measures and in fact even slightly lower.

 

Figure 2 - Index Issuer Volatility Risk vs. CDX.NA.IG

In addition, the IVR skew parameter in Figure 3, shows a near record level of flatness in Q1-2019, moving back from the brief December spike to the lower levels seen through much of 2018. Skew measures the extent to which out of the money puts have higher volatility than near or at the money options and is another form of a “fear” measure since it can express the premium paid for tail risk. The market presently places a low premium on broad-based tail risk. That is consistent with the sentiment shift and declining credit spreads.

Figure 3 - Skew parameter in IVR model (inverted axis with lower skew corresponding to a higher value)

Overall the view from the equity options market aligns with the credit sentiment series. The cross-asset class view of IVR expresses low credit risk and also reflects the lack of interest in the allocation of capital to immunizing tail risk. It can be valuable to monitor all these measures to stay abreast of when there are statistical departures, and historically it tends to vary as to whether the credit market or its equity derivatives market responds first to factors impacting credit spreads.

 

Robert Levy

Head of Business Development

rlevy@hanweck.com