$VIX – http://blog.gavekalcapital.com/?p=11556

The relationship between the VIX and the spread between high yield bonds over 10-year treasuries is highly correlated (87% over the past 15 years). This, of course, makes intuitive sense. The VIX tends to spike when confidence in stocks or the economy is shaky. Which is also true for high yield bonds. When investors begin to worry that high yield issuers won’t be able to make debt payments because of, for example, slowing growth, high yield bonds usually sell off against treasury bonds.

This occurred earlier this year in February when the VIX spiked to over 28 and the spreads widened to 850 bps. Since then as investors climb the wall of worry the level of the VIX and high yield spreads have fallen in tandem. However, the level of the VIX has fallen much further and signifies that fears in the equity market are much lower than fears in the bond market.

At no point over the past 15 years has this level of the VIX occurred when high yield bond spreads are this elevated. A simple regression model suggests that the VIX should be around 19 rather than the current level of 12. Or looked at from the other angle, high yield spreads are usually 185 bps lower than they currently are when the VIX is at 12.

Presumably, this relationship will begin to normalize. The question that needs to be answered is will it normalize because investors bid up high yield bonds or because the complacency in the stock market erodes away?