The VIX: A Canary in the Coal Mine?
Over two decades ago, we integrated the VIX (short for Volatility Index) into our credit models, long before it became commonplace in the financial industry. This 'fear gauge' has been instrumental in shaping our investment strategies ever since.
Currently hovering around 18, the VIX is not alarmingly high by historical standards, and is well below the levels seen in early August. Yet it is notably still 20% above its average over the past year. This flashing amber light hints at potential market turbulence and a shift in investor sentiment. Though not yet at levels that would suggest a crisis, this signal deserves our attention due to its profound implications for portfolio management and risk assessment.
The VIX reflects market expectations of future volatility, derived from S&P 500 index options prices. A rising VIX indicates anticipated market turbulence, prompting risk-averse investors to reassess their portfolios. This often translates into a shift away from riskier assets towards safer havens like bonds or cash.
More importantly, the VIX's impact on Value at Risk (VaR), a crucial risk management metric, drives investor behaviour. As volatility surges, so does VaR, signalling increased potential for portfolio losses. This prompts risk-conscious investors to de-risk, aligning their portfolios with their risk tolerance.
The interplay between the VIX and VaR is often underestimated. Volatility is measured over a period, so recent spikes gradually feed into longer-term measures, causing risk-based metrics like VaR to rise. This, in turn, triggers further de-risking, potentially creating a self-fulfilling prophecy of market downturns.
While other factors contribute to our current focus on single-A rated credit, the VIX's movements are crucial. This is precisely why we are closely watching the VIX. To prevent longer-term volatility measures from rising, we need short-term volatility to subside, which is not happening at the moment.
We have observed a recent trend in investors trimming riskier positions in favour of fixed income in recent weeks. Until the VIX subsides, this trend is likely to persist, underscoring the importance of understanding and responding to this key market indicator.
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