Keep an Eye on What Credit Investors Are Doing

Options traders are loading up on junk bonds

Senior Vice President of Research
Aug 16, 2021 at 8:49 AM
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The heart of earnings season is behind us, which means any individual equity hedges related to adverse earnings moves may now turn to more macro hedges. Investors continue to weigh the potential of a slowing world economy as Covid-19 cases and hospitalizations pick up pace and supply chains get disrupted. Additionally, the Taliban re-gained control of the Afghan capital over the weekend as China economic data came in lower than expected.

Additionally, on the heels of several comments from Fed governors the past couple of weeks about the U.S. economy either meeting or getting close to objectives that will allow the Fed to taper bond purchases, it is safe to assume that the Federal Reserve will garner even more attention from investors as we move into the second half of August.

Specifically, Federal Reserve Board Chairman Jerome Powell will host a town hall with educators and students on Tuesday, Aug. 17 at 1:30 p.m. eastern time. Mr. Powell will respond to questions asked by participants who will join the event virtually from across the country. Investors will be looking for hints on any new developments with respect to where the Chair stands on a tapering timeline and when he sees the Fed lifting rates. And later the following week, the Federal Reserve Bank of Kansas City hosts dozens of central bankers, policymakers, academics and economists from around the world at its annual economic policy symposium in Jackson Hole, Wyoming. Symposium participants include prominent central bankers, finance ministers, academics, and financial market participants from around the world. This meeting has historically brought announcements on shifts in Fed policy, if there is a shift or pivot of some kind.

… there has been a run on Eurodollar options betting the Federal Reserve will opt not to raise interest rates at all. Traders this week have been busy snapping up Eurodollar call options on underlying March 2025 futures that target three-month Libor to fix below 0.5%. These pay off if markets price the Fed keeping its benchmark at its lower bound until thenA scenario where the Fed ends up holding rates near record lows through to 2025 would probably mean that the global economy fails to recover from the pandemic"

            -Bloomberg August 13, 2021

After reading the excerpted article above on Friday, it reminded me of an observation that I made on the trading floor a few weeks ago, when I noticed huge put activity on the iShares iBoxx $ High Yield Corporate Bond ETF (HYG--87.46).

The graphs below display the put open interest build on the exchange-traded fund. At the time, I hypothesized one or a combination of three things going on with this activity:

  1. Purely speculative bets against junk bonds, as investors bet against an economic recovery and companies with weak balance sheets suffer the consequences.
  2. A way to bet against a financial accident and with cheaper option premiums (HYG options command single-digit volatility readings whereas double-digit readings prevail on equity index options), and/or
  3. Hedges to long junk bond positions as investors gravitate to high-yielding bonds because there are little other alternatives in this low interest rate environment (CNBC posted a graph on television in late July displaying an extremely low implied default rate on high-yield bonds – the lowest since readings prior to the 2000 and 2008 equity bear markets).

 

HYG MMO

Much has been made of the fact that equity market skew -- a measure of how expensive bearish bets are relative to bullish contracts -- has been hovering near all-time highs. However, it’s a similar set-up in the corporate credit market, Goldman notes, where a large spread between implied vol on 25-delta payers and 25-delta receivers normalized by at-the-money contracts suggests ‘the relative price of downside protection has never been more expensive.’”

            -Bloomberg News, July 2, 2021

With the Fed in focus during the next couple of weeks, I am bringing this topic up because the media has highlighted how much optimism there is among market players. There is truth to this, particularly among retail market participants.

However, a fair amount of caution seems to be co-existing with the optimism, albeit the caution is not readily apparent, since it is being played out on various derivative instruments within the credit markets that aren’t as popular and widely followed by the average investor.  

Whether it is fear of a Fed policy mistake and/or the Covid-19 delta variant wreaking havoc on the impressive economic growth we have experienced in 2021, something is worrying the corporate credit markets. And to the extent the equity market is tied to and correlated with the corporate bond market, one could reason that market participants are not in a state of euphoria like the media likes to point out, suggesting expectations may not be as high was we think. That said, as an equity investor, it may be wise to be open to the possibility that credit investors know something that equity market participants do not, so that you can change your views quickly if forced to do so. 

With short interest on S&P 500 Index (SPX--4,468.00) components at multi-year lows and equity option buyers displaying optimism, albeit not in the extreme sense that we saw a few weeks ago, the optimism that we are seeing among equity market participants at present is warranted. For example, the SPX continues to trade within a bullish channel that has been in place for eight months, and it is above the 50-day and 80-day moving averages that have acted as support on pullbacks this year.

As I have said multiple times, do not disturb long positions unless and until there is an extended time period in which the SPX trades below its channel, or moving averages that have held pullbacks this year are no longer holding as support. Such technical deterioration could set the stage for an unwinding of the optimism that is on display in the equity market.

As we look ahead to August standard expiration week, the SPX is just below the 4,475 level, which is double the March 2020 closing low of 2,237.40. Many investors may be anchored to this low and be tempted to take some money off the table if the index doubles the 2020 closing trough. Just overhead is the round 4,500 level, which is also the site of the top of its channel to start of the week. The bottom of the channel ranges between 4,363 on Monday and 4,387 on expiration Friday.

Speaking of expiration, I don’t see major delta-hedge buying or selling in the cards this week, as there is not a major build up of call or put open interest at any strikes in the immediate vicinity of the SPDR S&P 500 ETF Trust (SPY--$445.92). The SPY 440-strike, which is equivalent to 4,400 on the SPX, is the strike with the biggest call and put open interest. It could be supportive if a SPX decline emerges this week, suggesting such a decline would be relatively shallow.

SPY Open InterestSPX Daily 50 80 MAs

Todd Salamone is Schaeffer's Senior V.P. of Research

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