Back in 1999 one of our team members published a U.S. Portfolio Strategy piece. It centered on: A Volatility Framework For The Corporate Market. One of the key concepts was looking at the relationship between volatility and corporate credit spreads. Furthermore, when the two components are looked at as a ratio, we can see how much one is being AND has historically been compensated in terms of credit spread per unit of equity volatility.
Since it is something that we have internally called the Compensation Ratio and remains a measure of risk we keep it at the center of our investment and risk processes.
Below is a chart over the past 15yrs of U.S. Credit Spreads (OAS) and implied equity volatility (6 Month VIX Futures). You can see that historically the two are closely related; however, right now we are observing a noteworthy divergence—the implied equity volatility remains historically high, while credit spreads flirt with historic lows.
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Taken together, in the form of the Compensation Ratio, one can see that in the past 15yrs a generic creditor has never been compensated less for a given amount of implied equity volatility.
Ultimately, as we navigate the current market dynamics our eyes are very wide open to the risk and reward undercurrents, as it pertains to this risk metric and others, where we are practicing ever more judicious selectivity in our portfolios.
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