The clearance of these two major impediments has led investors to turn their focus into hopes of a quick economic recovery and, consequently, rapidly improving fundamentals. This trend reversal has been particularly apparent in the major equity strategy reversal in which market participants have started to sell the top to buy the bottom. That is to say, sell growth stocks to buy value and cyclical stocks.

This equity strategy reversal is of particular interest for corporate credit as spreads are, in principle, negatively correlated to equity market movements (when equity prices rise, corporate spreads tend to compress). This strong relationship becomes especially relevant in extremely volatile periods, as is currently the case. In other words, correlations between equity and corporate credit spreads tend to be ~ -1 in periods of high equity volatility, adding close to no diversification benefits during market peaks. This market alleged diversification benefit only seems to prove true in sideways trading periods. Interestingly, this inverse relationship works in both ends of the risk spectrum, meaning that the relationship between equity and corporate credit spreads also approaches ~ -1 in periods of extreme equity frothiness, as is currently the case. However, it is important to acknowledge that, even if the correlation is close to -1, the sensitivity is far different as corporate performance is far less volatile than that of equities.

But how do we account for this interdependent relationship between equity and credit spreads while acknowledging the exacerbated dependence in periods of high volatility? In order to accomplish that, we use two equity implied volatility indicators (VIX for the US and Vstoxx for the Eurozone) to capture this somehow permanent dependency in periods of high uncertainty. Of course, it is necessary to acknowledge that we are using an implied volatility estimate to proxy realized volatility. This is important as implied volatility is structurally higher than realized volatility and also more sensitive to erratic market moves. Lastly, it is worth noting that literature has already approximated this direct relationship as is the case for Merton’s credit risk model, which explains corporate credit spreads as a function of the volatility of the assets owned by a company.