Equity market investors have become used to their volatility measure, the CBOE Vix, ticking up in recent days, and Friday was another notable spike.

CBOE Vix 

As of this month, credit professionals have similar volatility measures they can refer to, thanks to IHS Markit / S&P teaming up with CBOE to provide Vix indices for the iTraxx and CDX indices. Launched in mid-October, these provide useful insight on the firmness (or otherwise) of prevailing credit markets as windows for borrowers to issue debt look increasingly squeezed. 

Here in Transylvanian colour scheme is what the CDX/CBOE NA HY one-month VIX shows for 2023 so far:

CBOE/CDX HY one-month volatility in bps — via S&P

On first glance one might say, well we are easily within the year’s range. But let’s remember that the start of 2023 wasn’t great and March felt close to panic level, given what was happening with US regional banks and Credit Suisse. 

A more pertinent observation is that, even at this level of elevation, the number of pulled primary market loans and bonds is starting to stack up. If the iTraxx and CDX Vixes stay at such levels or continue higher then it could well mean primary hits a lengthier impasse. 

So far, some market participants have brushed off pulled deals as merely the result of opportunistic approaches by borrowers that weren’t that bothered — with much the same bravado as Tyson Fury might brush off his third-round knockdown by Francis Ngannou as a lucky clip round the head. But pulled deals keep happening and, as my colleague Sasha Padbidri wrote yesterday (Monday), the latest pulled US loan deals and two weeks of stalled bonds suggest a different narrative. Rather like Fury’s black eye and cut forehead, borrowers have the evidence to know they are in a much tougher fight. 

There’s another moment of uncanny high yield credit bidding as I write, with Crossover heading back to 450bps along with an eerie calm in equities. But this feels like the set up before a jump scare. Most immediately, the US Federal Reserve is underway with its trick or treat. Beyond that, I wager November is going to be even more challenging than October. 

The S&P 500 is still up 9% on the year, carried by a few big tech names, but its retreat from the highs has gathered alarming momentum. Other stock and bond indices, along with ETFs, are faring worse — having undone all their earlier gains or gone into negative territory.

iShares iBoxx $ High Yield Corporate Bond ETF

Jumpiness at these psychological levels means headlines don’t need to be very dramatic to prompt big moves. There are catalysts aplenty to send spreads sharply wider or tighter — from central bank meetings this week, to government bond yield oscillations, earnings, and the escalating Israel-Gaza conflict.

Rather than tracking all these moving parts, as I’ve attempted in previous editions, I thought I’d take a step back and consider the accumulative effect of market dynamics that are staying persistently out of the norm. My literary inspiration this week is The Picture of Dorian Gray by Oscar Wilde, since the long maintained outward appearance of a benign market is revealing its hidden unsavoury aspect. We need to talk about the ravages of time and excess.

September levfin investor versus October… picture source: Literary Hub 

As Wilde wrote: “Some things are more precious because they don't last long”.

In the global financial crisis of 2008/9, the scale of spread widening and asset write-downs grabbed headlines. A less studied aspect was the effect of time on wrecking liquidity. My analogy for what happened back then was a slowdown of traffic on the credit highway that started to produce an almighty jam. In those circumstances, with everyone getting blocked in by the same market forces, even healthy vehicle engines only had a certain window of safety before they too ran out of fuel. Each time that happened, an engine stalled and the vehicle became another constituent part of the blockage, making the problem exponentially more difficult to solve.

Another way of looking this: at times of crisis, everything becomes highly correlated. So highly correlated, in fact, that the GFC caused Gaussian copula models of correlation (devised by David Li and enshrined in the Basel II regulatory framework for banks’ structured credit capital requirements) to spit out values greater than one — which meant, as any quant can explain better than me, that the models were broken. 

If you’ll forgive another analogy, it was like a rubber band had been pulled back so far it either had to snap back painfully (carrying everything with it) or would rupture.

We’re not at that point today, and thankfully correlation models have moved on. But my point is that it makes sense to look not just at the extent of credit spread widening but also the amount of time that markets are grappling with elevated spreads. Volatility is bad for companies that need to issue, but so is the prolonged suffocation of high borrowing costs — particularly for those that racked up a lot of debt when the going was much more favourable. 

As a crude measure one could look at historical levels of the CDX HY index and say, perhaps a bit arbitrarily, that anything below 300bps depicts a market firmly in the green, with 300-400bps the amber/neutral range, and above 400bps the red zone.

CDX HY historical five-year spread levels in bps — via IHS Markit, with author’s 400bps line insertion

(I say arbitrarily, but actually this is not dissimilar in concept to a form of credit linked notes bank structured products desks have sold over the years. With such a CLN, the investor might earn a return for every day the referenced spread was within, say, a 0-400bps range, but lose that return for every day above that. This is the same idea but with overall market health the focus rather than an individual investor contract.)

On this reckoning, while the spread blowout in 2020 during the Covid-19 pandemic was severe, the resulting red area under the chart was far less extenuated than during the GFC, or even the subsequent European sovereign crisis — and less than what we’ve been dealing with since the second half of 2022. There was simply a lot less time for liquidity issues to mount up and damage otherwise healthy corporate borrowers, so the spate of defaults that happened around that time were mostly companies that were already on the verge of succumbing to their debt burdens before lockdowns began.

That said, the outsized response of governments and central banks to pump liquidity into the system is a big part of why things are the way they are today. Everyone fuelled up on debt at very (artificially induced) cheap levels. It’s been widely opined as a result that corporate borrower and bank capital balances were in much better shape going into 2023 and so liquidity was not such a concern despite the challenges besetting primary markets. But how long can spreads remain at such elevated levels (500bps+ for CDX HY) before the traffic slowdown starts to bite?

“Punctuality is the thief of time,” wrote Wilde. And I would say the reckoning for markets we’ve been talking about since the early part of this year — ie a downturn beginning Q4 2023 — has come bang on cue. The question is how long that escalates, and how many levels of market support it breaks through. 

The real trouble for risk assets starts when technical / artificial props start to fall away. One disconcerting image of the past week came from former Citi credit strategy head Matt King, who pointed out in research for his new venture Sartori Insights that a key part of the yield cycle is being overlooked. 

“Central banks didn't withdraw the $1trn in liquidity we were all expecting under QT,” he wrote. “They added $800bn.”

This has put markets in the phase of ‘getting real’, but with an ensuing flight to quality nailed on.

My observation about time spent by credit at extenuated spread levels could as easily be applied to any market measure — ‘sticky’ inflation, central bank rates, the protracted inversion of US Treasury yield curves, the price of oil above its historical average, global PMIs in the red, the cost to homeowners of variable rate mortgages… these things are of course highly correlated and have gone unalleviated for too long. It is the moment of snap back that maps with the biggest damage to markets, however, and we are seeing that get underway in concert.

No wonder then that there is talk of windows having closed for parts of the credit primary market. With CLOs, that translates to managers finding difficulty shifting parts of new deals’ capital structures. But at least for now new CLOs are still getting done — and so a crucial pillar of borrower support is kept in motion. Amend and extend deals have propped up the leveraged loan market, and — despite reinvestment period concerns — CLOs continue to prop up A&Es. 

Unlike 2020, there is little hope there will be massive further injections of support from central banks and governments. Quite the opposite is happening from here, as higher-for-longer translates to slower-for-longer procession on the credit highway. Neither is there much economic growth greasing the wheels. As such, the weight of wider spreads needs some other means of alleviation. The quicker the better.

“All art is at once surface and symbol,” observed Wilde in The Picture of Dorian Gray. “Those who go beneath the surface do so at their peril.”