New bond market ‘fear gauges’ will warn of trouble—but could be trouble themselves

The 30-year-old CBOE Volatility Index, known by its ticker VIX, is well-known as a useful measure of the stock market’s riskiness. It falls when stocks rise, and vice versa.

Hence its nickname, the "fear gauge."

Now, its backers are rolling out similar tools for the bond markets. They, too, could be useful benchmarks—just think twice before investing in them directly.

Investors lost untold millions investing in an exchange-traded fund (ETF) based on the VIX during the Great Recession. Same for the meme-stock Robinhood generation that lost its shirt on the index during Covid.

Both groups had, sensibly, thought that buying an investment that went up when the markets went haywire sounded smart in turbulent times. But the structure of volatility indexes meant these ETFs almost always tanked.

The new bond "fear gauges" aren't any different.

Bond market “fear gauges”

The bond markets have been hammered in the last three years.

If you bought a 30-year Treasury bond at auction in mid-2020, it had a yield of about 1.5%. New 30-year Treasuries now yield nearly 5%, meaning people who bought one three years ago and must sell it today, rather than holding onto it until it matures, will lose half their money.

A similar story is true of corporate debt, both high-grade and junk bonds.

In other words, the 40-year bull market in bonds, during which rates always went down and prices always went up, is apparently over, and no one knows what will happen next.

To shed some light on just how risky bonds are these days, CBOE Global Markets and S&P Dow Jones Indices, who produce the stock VIX index, decided to roll out four new indexes for bonds on Oct. 13.

There are two for North American markets (one for junk bonds, and one for investment grade bonds) and two for European markets.

These indexes are a little complicated. They use information from a type of security called a credit default swap to determine how volatile a particular type of bond is.

Volatility is the usual metric for risk because it measures how much a bond’s price fluctuates. The more it moves around, the greater the chance it will be in a losing position when you want to sell.

So, that’s useful information to have.

The problem comes when crafty investment firms package these indexes as ETFs and tout them as a way to hedge against market losses.

That’s because of the way they are designed. Their architecture works fine as stand-alone indexes, but they have a fatal flaw when used as the basis for investment products like ETFs.

Take the example of the first ETF to be based on the stock VIX index. It had the ticker symbol VXX and was launched in January 2009, just months after Lehman Brothers’ bankruptcy, during the worst of the Great Recession.

Unfortunately, as you can see below, it did not track the VIX index well. Instead, it dropped like a stone, and investors who bought that ETF lost their shirts.

Why do these indexes make bad investments?

The approach used to create these indexes is similar whether they track stock or bond market risk.

In the stock market case, the backers buy a series of one-month futures contracts on the S&P 500. The price movement of these contracts—which allow a buyer and seller to agree to a price for something that will be exchanged in the future—determines how the index behaves.

Unfortunately, sometimes futures markets display a behavior that is called “contango.” This means that future prices are higher than current, or “spot”, prices.

Since the VIX uses one-month futures contracts, at the end of each month, the VXX ETF that tracked it received a payment for the maturing contract and had to go out and buy the next month’s contract.

Only, in a market in contango, the next month’s contract is slightly more expensive.

So, each month, the index and ETF backers were losing a little bit of money, selling one contract for, say, $100 and buying the next month’s contract for, say, $101. After a while, that seriously eats into returns and dooms any investment product, like an ETF, based on the index.

The new bond indexes are based on a different type of contract, a credit default swap, rather than a stock futures contract. But similar problems could occur if those swap markets expect the prices they track to rise in the future.

For people with investments in Treasuries, money market funds, bond ETFs like TLT and JNK, or mutual funds like those managed by big bond houses like Pimco, Blackrock, Lazard, or JP Morgan, it might make sense to peek at the new bond VIX indexes from time to time.

But until their backers have solved the contango problem, investing in them may prove to be counterproductive.