A Look at Risk

Risk in equity and bond markets have dropped to near pre-spring COVID-19 lockdowns. Implied volatility in the S&P 500 and NASDAQ-100 edged higher this fall but have dropped after the election to near February levels. Credit risk, as measured in this case by the high yield spread, also dropped following the election.

The top panel highlights the equity volatility (blue & green), HY spread (red), and even the TED spread (orange). All show a spike, from very low levels, in the spring as COVID-19 surged and uncertainty was high.

The lower panel shows the S&P 500 (blue) and the yield on the HY index (red). Stocks have reached highs and yields are near lows. Note that while the HY spread is not quite at pre-COVID levels, the absolute yield is at lows. A 5% yield on junk is very low and offers little protection from potential default risk.

A drop in risk makes sense with the election behind us and positive announcements on vaccines and therapeutics. However, the higher number of positive virus tests, increase in hospitalization, and renewed push to clamp down on activity suggests we may want to reassess the optimism. On the other hand, momentum is a powerful force, especially at year-end.