The link between corporate credit and equity risk is well-established and forms the backbone of our tactical asset allocation (TAA) strategy. At the index level, the connection can be harder to track given that the best credit indices to pair with equity tend to be fairly obscure. One of the reasons we chose the Bank of America/Merrill Lynch High Yield B (HY/B) index for our TAA strategy was that data are readily available via the Fed’s FRED database. Despite the strength of the signal provided by the HY/B, it is no match for a proprietary index composed of single-name corporate credits selected specifically for their correlation to the equity markets.
Today, we introduce the Capital Context Corporate Index (C3I). The C3I is composed of 50 corporate credits that were chosen based on the correlation of their credit risk to the S&P 500 index. Starting today, our stock indicator value will reflect the disconnect between the C3I and the S&P 500 (as opposed to our original TAA model’s pairing of the HY/B and Russell 2000).
Why make the change? Three reasons. First, the C3I provides better performance for our TAA strategy. Really, this is reason enough. Second, we are able to update the C3I in near real-time which enables us to change our asset allocation on the day the credit and equity markets move from rich-to-cheap or cheap-to-rich, as opposed to waiting for an after-close index level like the HY/B. Third, we believe there is inherent value in a credit index that is more correlated to the equity markets than the current published indices.
The bond and stock markets will continue to become ever more tightly connected. Ignoring this fact leaves money managers open to capital structure risk in both bond and stock portfolios. A fixed income (bond) asset manager is accustomed to hedging interest rate and currency risk, but does not possess a straightforward vehicle for hedging equity market risk that is tied directly to the credit market. As we’ve shown with our TAA strategy, an equity portfolio manager can benefit greatly from paying attention to developments in the credit market. Finally, relative value traders do not currently have a credit security they can easily trade against stocks. This leads us to a modest proposal.
A Modest Proposal – Create a Credit Futures Contract
While the C3I provides immediate value through its use in our TAA strategy, the potential for a futures contract based on the index is immense. Imagine an exchange-traded credit futures contract that is nicely correlated to the equity market and enables traders to take on or lay off credit risk. A fixed income portfolio manager would be able to add liquidity to their credit portfolio and hedge equity risk. Hedge funds would gain a liquid instrument for trading credit, either against equities or independently. High frequency traders would gain a new security to trade that would pair nicely with S&P 500 futures.
Of course, existing credit dealers hate proposals like this as exchange-traded securities place their nice, fat margins at risk. Trust us, we recognize that launching a successful futures contract is not an easy endeavor. However, we believe we can learn from past attempts and adding more liquidity in creditland using a security with a tighter coupling to stocks is worth pursuing. Capital structure risk is real. Why not make hedging it easier?