FOR INSTITUTIONAL, PROFESSIONAL AND PERMITTED QUALIFIED INVESTORS. FOR PUBLIC DISTRIBUTION IN THE U.S.

FIXED INCOME STRATEGY • NOVEMBER 2017

Turning stocks into bonds

The search for yield has driven many income investors into unfamiliar territory. Low
yields on perceived safe assets have led many to embrace more credit risk. And
some have ventured beyond the bond markets – not just into dividend-paying equities
– but also options-selling strategies in equities. Such strategies don’t literally turn
stocks into bonds, but they do create similar risk profiles: limited upside potential with
plenty of downside. This month we delve into the links between credit spreads and
equity volatility – and revisit our late-October downgrade of U.S. credit to neutral.

Jeffrey Rosenberg Highlights

Chief Fixed Income Strategist, • The risk of loading up on credit and extracting income by selling volatility rises
BlackRock Investment Institute disproportionately as credit spreads narrow and vol falls further. These strategies
offer a high probability of small gains with a small chance of large losses.

• Today’s low-volatility regime could last a long time – especially against a backdrop
of economic stability. Reaching for yield through credit and selling options can be
self-reinforcing, driving volatility lower on the way down, but exacerbating any
reversals on the way up. We think this risk bears watching.

• The economic backdrop is supportive of credit but we prefer to take risk in equities.
Within credit we advocate an up-in-quality stance. And we see interest rate
normalization by the Federal Reserve gradually restoring the attractiveness of
lower-risk fixed income sectors, reducing investors’ temptation to stretch for yield.
Stephan Bassas
Portfolio Manager, Widening credit spreads; volatility up
BlackRock’s U.S. Investment Grade The risk-on tone has taken a breather in November, with credit spreads widening after
Credit team hitting post-crisis tights. Similarly, equity volatility (the VIX) bounced off an all-time
low, while the U.S. Treasury yield curve has flattened to levels last seen in 2007.

Bond market summary

Source: Bloomberg, as of November 15, 2017. Notes: Performance and yields are represented by the S&P Leveraged
Loan Index (bank loans); J.P Morgan EMBI Global Diversified Index (EM hard-currency debt), J.P. Morgan Asia Credit
Index (Asia fixed income), and the respective Barclays Bloomberg indexes for the remaining sectors. Yields are yield
to maturity, except U.S. high yield and municipal bonds (yield to worst). Performance is measured in total returns and
in U.S. dollars, except for Euro credit (euros). Our TIPS view reflects relative performance vs. nominal Treasuries.
Indexes are unmanaged and used for illustrative purposes only. They are not intended to be indicative of any fund or
strategy’s performance. It is not possible to invest directly in an index. Past performance is no guarantee of future
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The link between credit and equity vol
Our recent downgrade of U.S. credit reflects a preference for
taking economic and related corporate risks in equity versus
debt. We do not view corporate credit in isolation – or in
comparison only to the fixed income alternatives. Our asset
view recommendations contemplate asset allocation across
both debt and equity. We see better prospects for equities in
an environment of steady economic expansion, easy
financial conditions and strong corporate earnings.
Valuations also matter. Credit spreads have tightened
globally and U.S. credit spreads are at the narrow end of
their 17-year range against government bonds – even after a
recent widening. When credit spreads are this tight, even a
relatively small sell-off can wipe out the income advantage of
credit over government bonds.
Today’s tight credit spreads reflect low levels of market
volatility. Credit spreads historically have shown a close
relationship with the VIX gauge of U.S. equity market implied
volatility. See the Joined at the hip chart. And this is no
coincidence: The credit and equity markets are intimately
related. To understand why consider the payoff profile of
corporate debt: In the best scenarios you get your money
back and under the worst (the issuer defaults) you do not.
That return profile is equivalent to bondholders having sold a
put option on the value of the firm, an insight highlighted by
Robert Merton’s seminal 1974 work, On the pricing of
corporate debt. Demand for liquidity also tends to decline in
low volatility environments, another factor behind the
relationship between credit spreads and volatility.
Low volatility regimes tend to persist, and today's low vol
environment benefits from strong economic support, as
detailed by my colleagues in Learning to live with low vol of
July 2017. Yet today's realized levels of volatility stand at
historically low levels – even for a low vol regime. This is
true across markets. Such calm may mask vulnerabilities;
the concentration of income-seeking strategies and their
risks is a potential one worth keeping tabs on.
Joined at the hip
U.S. credit spreads versus implied equity volatility
Source: BlackRock Investment Institute, with data from Thomson Reuters,
November 2017. Notes: Credit spread is represented by the option adjusted spread
of the Bloomberg Barclays U.S. Aggregate Corporate Index. Equity volatility is
represented by the Chicago Board Options Exchange Volatility Index (the VIX).
Selling my upside
Risk of a covered call-writing strategy at different vol levels
Source: BlackRock Investment Institute, with data from Bloomberg, November
2017. Notes: The figure shows the risk (defined as the ratio of the potential loss to
expected gain at expiry of option) at different levels of S&P 500 implied volatility for
a covered call writing strategy that varies moneyness to achieve a constant 3%
annualized yield.
Selling options for income
Lenders, credit investors and insurance companies profit by
accepting downside risk in exchange for some capped
upside. The key to success is getting enough income (or
premiums) for the risk. The same idea applies to volatility
and credit spreads: selling options to generate income. In
the case of the corporate bond, it’s effectively an option on
default. In a covered-call strategy – one popular way of
generating income in the equity market – it’s selling some of
the upside return potential in a stock for income today.
Lower volatility and tighter credit spreads make it harder to
generate income from such strategies. Investors’ response
has been to stretch their risk profiles to meet income goals.
The dynamic is reflected in rising levels of corporate
leverage and fewer protections for creditors – in capital
structures that increasingly favor the interests of issuers.
In volatility we see similar dynamics. Consider a covered-call
writing strategy that seeks to maintain a 3% annualized yield
target. The investor owns a stock and sells call options on
that same stock to generate income. In exchange for this
income, the writer of the call gives away any potential upside
above the option’s strike price.
Lower levels of implied volatility mean less income from
each call option sold. The investor needs to sell more
valuable options to meet the income goal. In this case that
means options with strike prices closer to today’s level. But
selling near to “in the money” options reduces investors’
upside potential while maintaining all the downside risk
inherent in owning a stock. The end result: Income-seeking
investors in such strategies are accepting much greater risk
for smaller gains. See the Selling my upside chart. This is a
similar asymmetry of returns faced by credit investors today.
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Selling upside – and downside
Another response to a low-volatility environment? Sell not
only call options, but put options as well. Such short
“straddle” strategies do well as long as stocks don’t move
significantly up or down. In other words, investors pocket
income when stock volatility remains low. Such strategies
have been immensely profitable in the post-crisis period.
This reflects low and falling volatility – and the premium
investors have been willing to pay for protection. Since the
financial crisis, volatility has become an asset class unto
itself. Rock-bottom yields and investors’ post-crisis
preference for income over risky assets are the reason. The
result: on top of demand for traditional income funds, a
proliferation of income-generating strategies in the options
markets. These range from explicit short-vol strategies to
covered call writing, straddles, strangles, “iron condors” and
a multitude of structured products.
Short VIX and other option-selling strategies such as put or
call writing have led to surging volumes of shorting options,
reflected in a seven-fold rise in short VIX futures positions
since 2011 according to CFTC data. Such strategies have
been very profitable, as have many credit strategies. See the
Abnormal returns chart, which shows the Sharpe ratio – a
measure of risk-adjusted returns – for a variety of simple
income strategies. Higher risk credit – with lower liquidity –
and short options strategies have registered eye-popping
Sharpe ratios that are well in excess of historical norms. Yet
low realized volatility may be making these strategies appear
less risky than they are, as we will explain on the right.
Abnormal returns
Sharpe ratios by asset class
Source: BlackRock Investment Institute, with data from Bloomberg, November
2017. Notes: The Sharpe ratio is the average weekly excess return divided by the
volatility of returns. Indexes used: Bloomberg Barclays U.S. Aggregate, Bloomberg
Barclays Euro Aggregate, S&P/LSTA Leveraged Loan, Bloomberg Barclays Pan-
European High Yield, CBOE S&P 500 BuyWrite, S&P 500 VIX Short-Term Excess
Return MCAP, Bloomberg Barclays US Corporate High Yield, J.P. Morgan JACI
Diversified (Spread Return), J.P. Morgan EMBI Global Diversified (Spread Return).
Skew goes vertical
Number of call options per put option
Source: BlackRock Investment Institute, with data from Macro Risk Advisors,
November 2017. Notes: The chart shows the price ratio of a three-month 95%
put option and three-month 105% call option on the S&P 500 Index over time.
Consequences of low vol
The number of income strategies using options selling can
in itself affect the observation of volatility. Why? The
hedging behavior of those on the other side of these
trades can lead to the selling of up moves in stocks and
buying on dips. This itself dampens realized volatility.
Lower realized volatility, in turn, leads to declining implied
volatility. And that can create even greater selling
pressure in a self-reinforcing process: Sellers of volatility
need to sell progressively more options to meet income
needs. One manifestation of this behavior can be seen in
a huge spike in the relative pricing of out-of-the-money
puts versus calls. See the Skew goes vertical chart.
Such increases in the skew typically reflect demand for
insurance against downside risks, and we normally see
the skew rise in periods of low volatility. But the rise in
skew may also stem from persistent selling of upside calls
to generate income. The latter interpretation points to
potential financial vulnerabilities – even in a protracted
period of low volatility. The lack of severe market shocks
has led investors to sell volatility into any spikes. Such
strategies can be vulnerable to more persistent bouts of
uncertainty where a single spike is followed by more
increases rather than declines. And at low levels of
volatility, even small upward moves in uncertainty magnify
the potential for losses. This is particularly true for
leveraged forms of the short volatility trade.
Bottom line: The credit markets and income strategies in
equity volatility are exposed to similar risks. We still see a
role for credit in bond portfolios but overall, prefer to take
economic risk in equities. The Fed’s gradual interest rate
normalization is improving the outlook for less risky
income alternatives. This reduces the pressure for
investors to reach for yield, as detailed in Float like a
butterfly. Our higher quality fixed income preferences
reflect this restoration in value.
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BlackRock Investment Institute

The BlackRock Investment Institute (BII) provides connectivity between BlackRock’s portfolio managers, originates
economic and markets research and publishes investment insights. Our goals are to help our portfolio managers become
even better investors and to produce thought-provoking investment content for clients and policymakers.

B L AC K R O C K V I C E C H AI R M A N H E AD O F E C O N O M I C AN D M AR K E T S R E S E AR C H
Philipp Hildebrand Jean Boivin

G L O B AL C H I E F I N V E S T M E N T S T R AT E G I S T EXECUTIVE EDITOR
Richard Turnill Jack Reerink

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