When you’re watch­ing hor­ror movies, the time to worry is when things become eerily quiet. Last Fri­day, the market’s own mea­sure of fear, the Chicago Board Options Exchange Volatil­ity Index (VIX), hit its low­est level since last July. This is the finan­cial equiv­a­lent of eerily quiet.

The VIX tracks the implied volatil­ity on S&P 500 options. When investors are ner­vous, they’re more likely to pur­chase put pro­tec­tion, dri­ving up the cost of options and implied volatil­ity in the process. When mar­kets are calm, or investors are too com­pla­cent depend­ing on your point of view, the VIX tends to sink back into the teens.

At its cur­rent lev­els around 17 and 18, the VIX is mod­estly below its long-term aver­age of 20 and is well below its 2011 peak of nearly 50. It’s also below the mid 30s it hit in Octo­ber, when I argued that the VIX was too high and would likely mod­er­ate towards the high 20s or low 30s.

But while the VIX should cer­tainly be lower now than it was six months ago, I believe its cur­rent lev­els seem too low. While mar­ket con­di­tions have cer­tainly improved since the fall, it looks like investors may have become a bit too at ease. With the risks to Europe lin­ger­ing and most of the world still stuck in a lack­lus­ter recov­ery, a bit more cau­tion — or fear — may be warranted.

His­tor­i­cally, eco­nomic activ­ity, credit con­di­tions and mar­ket momen­tum are three key dri­vers of implied volatil­ity. All three have improved in recent months. Lead­ing indi­ca­tors have risen, mar­ket momen­tum has improved and credit spreads – mea­sured by the spread between the 10-year note and an index of high yield bonds – have con­tracted by around 1%. Thanks to the improved gen­eral mar­ket envi­ron­ment, the VIX should cer­tainly be lower than my Octo­ber fore­casts. How­ever, in my opin­ion, a fair cur­rent value for the VIX would be around the low to mid 20s, higher than today’s lev­els. And unless we see a fur­ther accel­er­a­tion in the econ­omy and more spread tight­en­ing, I would expect volatil­ity to post a mod­est rise in the com­ing months.

So assum­ing that volatil­ity is set to rise, how should investors adjust their port­fo­lios? First, remem­ber that it’s the change in, not the level of, volatil­ity that tends to impact asset prices. In an envi­ron­ment of ris­ing volatil­ity, investors would want to mod­estly lower their weight to mar­ket seg­ments that are very sen­si­tive to changes in volatil­ity and raise their weight to less sen­si­tive or lower beta instruments.

Prac­ti­cally, this could mean a mod­est real­lo­ca­tion out of high-yield fixed income towards investment-grade bonds, an asset class that cur­rently appears to be a bet­ter rel­a­tive value (poten­tial iShares solu­tion: LQD). While the spread between high yield and Trea­suries has con­tracted by roughly 200 basis points since Sep­tem­ber, the spread between Baa bonds and Trea­suries has been stuck at approx­i­mately 325 bps. Investors may also want to con­sider mod­estly increas­ing their weight to mega-cap equi­ties. This seg­ment of the mar­ket still trades at a sig­nif­i­cant dis­count to the broader mar­ket and is less sen­si­tive than other seg­ments to changes in volatil­ity (poten­tial iShares solu­tions: OEF, IOO, IDV, HDV).

Source: Bloomberg

Dis­clo­sure: Author is long LQD

Bonds and bond funds will decrease in value as inter­est rates rise

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