The coronavirus crisis has understandably caused a great deal of unrest on the financial markets. This article examines the opportunities and threats at times when share prices have fallen sharply in a short period of time, spreads have increased materially and fear in the financial markets is elevated. Our analysis identifies global high yield as historically having brought strong risk adjusted returns after periods of stress when compared to the numerous asset classes considered. However, the asset class is not homogeneous and managing default risk, especially following current market turmoil, will be key. Short-dated high yield in particular highlights interesting and enhanced yield opportunities for Dutch pension funds in relation to FTK capital requirement.
We define fear in the financial markets as a phenomenon characterized by an extreme sell-off and heightened volatility. The VIX is not only a measure of the implied volatility of the broad S&P 500 equity index, but it is also a good indicator of how much fear there is in the financial markets. For various asset classes, we investigated whether a peak in the VIX index has historically been a good time to buy or not when compared with the peak in the VIX index in March this year. We looked at the four highest historical peaks in the VIX index and examined the development of various asset classes after these peaks.
Figure 1: VIX index as of 16-Apr-2020. Source: Bloomberg and Aegon Asset Management
We first look at the risk-return ratios if one starts to invest three months after a spike in the VIX index. The period of three months has been chosen so that at the time of investing it is clear whether there is a peak in the VIX.
Source: Bloomberg and Aegon Asset Management. Indices used: Bloomberg Barclays Global High Yield, Bloomberg Barclays Global Agg Credit, MSCI World, MSCI Emerging Markets, IBOXX Eurozone Sovereign, Bloomberg Barclays Global Inflation-Linked, Bloomberg Barclays Pan European FRN ABS Bond and Bloomberg Barclays Pan Euro High Yield 1-5.5 Year Ba/B; all in Euro. Returns based on daily observations except for short-dated high yield (monthly observations).
The results of the analysis show that high yield and emerging markets debt presented the highest risk-adjusted returns after the selected peaks in the VIX index. They also showed higher returns in absolute terms than equities from both developed and emerging markets. The high volatilities of equity returns are also notable, resulting in lower risk-adjusted returns. In all of the four periods following a peak in the VIX index in the past, both global high yield and short-dated high yield led to a strong (statistically significant) positive return in the year following the peak. A robustness analysis showed that if the invested period is extended to two or three years, the results remain strongly positive for both global high yield and short-dated high yield.
But no crisis is the same. For the coronavirus crisis, the impact on corporates will depend, among other things, on how long the pandemic will last. The longer it continues, the greater the number of defaults and downgrades. In addition to expected returns and risks, Dutch pension funds will also have the task of balancing these risks against movements in FTK capital requirements.