Wall Street analysts have picked the next domino that they think will fall in financial markets as an escalation of the trade war continues to upend global equities.
Strategists at Weeden & Co., Cantor Fitzgerald & Co. and Macro Risk Advisors are taking one more step down the risk ladder and turning bearish on a junk-bond exchange-traded fund. High-yield debt may come under more stress as focus turns to the negative impacts the newest clash over cross-border commerce will have on American activity, according to analysts. And options that offer exposure to downside are cheaper in junk bonds than U.S. equities.
Investors are prepping for the worst-case scenario in trade -- a derailment of talks -- after the Trump Administration jacked up tariffs on Chinese goods and the Asian nation said it would retaliate, helping to push this week’s slide in equities to around 3%, the biggest decline since December.
“Equity volatility is once again highly dislocated versus high-yield credit spreads,’’ writes Peter Cecchini, global chief market strategist at Cantor Fitzgerald, who estimates that S&P 500 Index’s implied fluctuations are two standard deviations rich relative to their typical spread to swings in the junk space.
Thus, long-volatility strategies on the iShares iBoxx High Yield Corporate Bond ETF are attractive as “a way to hedge high-yield exposure or even as an outright bet to play the reversion of credit spreads to equity volatility.’’
On Thursday, Cecchini recommended a put spread trade that breaks even if the junk bond product falls 2.7% from its latest close by June 21, and has a maximum payout of nearly 10 times the premium paid should HYG fall 7% over that span.
Bank of America strategists said poor market conditions for individual corporate bonds can lead to more acute stress for assets that are more frequently traded, specifically, junk-linked exchange-traded funds.
“Times of significant market stress are associated with above-average discounts in ETFs, ranging from 0.15pts in late 2015 to 0.25pts in late 2018,’’ wrote Oleg Melentyev, head of U.S. credit strategy at Bank of America Merrill Lynch.
‘Catch Up’
Equity volatility has been more sensitive to the retreat in U.S. stocks than it was in the fourth quarter. In October, the S&P 500 was nearly 5% off record highs the first time the VIX cracked 20. This time, losses reach a little more than 2% before that threshold was breached. And it wasn’t until early December that the implied one-month correlation among index constituents hit 0.49. It only took two sessions into the current pull back until traders were already similarly scared about the prospects of everything tumbling at the same time.
“If trade tensions persist, high yield will ‘catch up’ with equities,’’ said Michael Purves, chief global strategist at Weeden & Co. In the fourth quarter, the pick-up in credit volatility and spread widening were relatively slow to occur because economic fundamentals remained fairly robust, he wrote in an note, but “as volatility persisted, it was only a matter of time until pan-asset de-risking caught up with the dramatic de-risking in equities.’’