Quantamentals: Oil, Vol Transitions, and Mean Reversion
December 31, 2015
Speed read: The energy equity discount to bonds isn’t cheap enough to buy the bottom of the capital structure. This month’s bond moves measured by z-scores show the chances of turmoil are much higher than normal.
Modern financial markets display a precarious stability premised on stat arb models that use historic vol as input and output risk limits, position sizing, leverage implied by history.
Start arb books are always short vol, meaning they suffer from a modest increase in vol. A transition from low vol to medium vol will hurt any stat arb book. What happens then depends on the trading strategy and whether tails are hedged in some fashion. It is the transition that kills especially because they are often very crowded trades.
A short-term trader can manage this: ride the trend until the reversal. Repeat. But stat arb books are getting hammered because the trend moves are too short for a momentum model to capture value. Oil has a historical annualized volatility of 30-40% and the last 2.5 years or so have been depressed. Now it is running a choppy 50-60%.
Multi-sigma moves in oil markets, have unsettled all markets. Partly market problems are due to volatility contagion and higher correlations across the market space. Overlaying VIX and rolling correlations show the connection of oil vol to common equity vol over an eight year period.
In the case of oil markets and equity, long vol serves as a straightforward hedge. Even when selling is concentrated in the energy sector, equities offer many tools for expressing a sector view: buy the sectors you like, buy the index and hedge the sectors you dislike, and so on. In credit, this issue is not so easy to resolve. Unlike equities, no sector-specific high-yield funds exist, and even if such existed, correlations in the credit space can be very strong and mute the benefit of diversification and sector selection. The only option is to sell the entire portfolio, or hedge the index given the basis risk.
The former in a generalized sense is happening in HY. Credit hedge funds are returning capital. Mutual funds owning $800 of high yield bonds have seen net outflows amounting to $50 billion. The contagion effect is real, but it is not delivering body blows to the space. Outside of energy and materials, the majority of cash bonds in the iBoxx index trade above par.
In turn, market unease is partly due to oil price levels impairing business earnings (moving common equity down) and balance sheets (moving credit down). So what is the outlook for oil?
There is a supply overhang that will take months to resolve. There is a demand slow-down, the rapier point being China. So oil may price at $25 maybe, for a few months. It will rebound in 2016 to some degree. Oil is just too useful to go away anytime soon. The world economy has never grown for more than a few months without using more and more oil. It is needed to move nearly everything that moves. More people mean more stuff to move, means more oil used. Batteries won’t make a dent in oil demand for another decade or so. Population won't peak until about 2050.
Oil prices impact both credit and equity. Bond yields and stock prices of energy companies in the S&P 500 show the same pressure.
Since 2010, energy equities show a small degree of underperformance to bonds on a total return basis. This matters because bond and equity returns are mean–reverting in the sense that equity returns converge to bond returns within that time frame.
This mean reverting feature implies a buying signal for equities: the greater the underperformance to debt, then greater the value in the risk premia. It is not safe nor is it a mean-reverting arbitrage to trade names with a meaningful chance of being insolvent. We are talking about solid names whose stocks offer deep discounts but the business models and free cash flows are positive. What has to be accepted in this trade is the same with any position trade: it can move further out of the money before it finally goes money good.
Another note: This month bonds made a massive move down, similar in magnitude to the equity moves. This is pretty unprecedented and indicative that the probability for further instability is high.
The equity discount isn’t steep enough and the massive bond moves signal that the chances of turmoil are higher than usual.
There is an intuition backing this up: before oil prices recover, there has to be a supply response. Either this means firms go bankrupt or production cuts. Companies that borrowed on the basis of higher prices are now struggling to repay lenders. The only reason that more of these companies haven’t gone bust already is that they bought hedges against commodity price declines. These bankruptcies will drive correlation effects across the space.
But frankly, energy names in high yield will be the least of the world’s problems if oil prices don’t recover. In the emerging world it will quickly translate into political disorder and regime change.