An increased leverage in the whole credit market
The VIX Index reflects the equity and options markets’ expectation of earnings volatility. Companies with deteriorating credit statistics are more likely to experience high equity price volatility than companies with a stable credit trend. As financial profiles of companies improve and the uncertainty about their future earnings declines the hedging costs to invest in those companies will come down and the VIX Index will decline.
High-yield market sensitivity to changes in VIX varies over time and it does not vary simply by ratings. The correlation will always increase when an increased leverage in the whole credit market can be observed. This is usually the case when CCC-rated companies have a high share of the credit market. So it can be stated that the CCC portion of the market drives the sensitivity between high yield and the VIX Index. A decline in implied equity market volatility results in lower risk premiums in the high-yield market.
The correlation between the VIX Index and high-yield spreads was only moderate at 0.45 during the period Dec. 1996–Nov. 2003. Ahigh correlation of 0.83 can be measured for the period Aug. 2000–Nov. 2003.
