Using the Russel 2000 level and Russell 2000 market cap volatility, rich/cheap of BB credit cpreads can be shown.

Input is the R2000 ETF and the Merrill Lynch BB OAS index.

The current level of the R2000 is depicted versus the SP 500, in log and price to show how rich the SP500 is to the Russell 2000.

The Merrill Lynch OAS BB Index

The Merrill Lynch OAS BB Index is scatter plotted against the R 2000 level and then again in log scale:

Stochastic analysis of BB credit using one year Russell 2000 asset volatility based upon one year realized volatility of the Russel 2000:

The Russell 2000 realized one year volatility is transformed via simultaneous equation into Russsell 2000 asset volatility, using the R2000 equity level and the R2000 debt level - the volatility of the market cap (debt and equity - “Vola” below):

Vole = [N(d1) X V X Vola] / E

The asset volatility, Vola, derived:

Asset Vol of the Russell 2000 is ploted to BB spreads providing a stochastic analysis.

Russell 2000 asset vol scatter:

The asset volitility, the “sigma”, or vol of the underlying, used in a standard Black Scholes formula to find the d2. Proce is not solved for, just d2, as the price asymtopes along the x axis is of little use for trading and risk management.

The d2 formula is well known:

The d2 depicts in units of volatility years (Brownian scaling of time) how far the underlying credit is from default given the current asset volatility, for a certain time period (we use 5 years) and for a certain interest rate or rho (we use 3%). The d2 is often called when using a Merton formula the “distance to default”, or D2D. D2D is plotted over time. While the Russell 2000 has sold off of late, the D2D of the Russell 2000 has crashed and has lost 1/2 the peak value during the low sub 10% volatility period before Feb 2018 this year. Currently D2D for the BB credit using Russell 2000 is 4.9229941 and a year ago D2D was 4.2703143 :

The above D2D is scatterplot against BB spread.

Current BB spread can widen substantially, doubling towards 3% to 4%. Volatility and the characteristics of vol changes, long dated vol, changes via regime shifts of jumps up or down. Volatility does not move in a discrete fashion as Russell 2000 price and likewise credit spreads, which we are showing are pricing volatility, will move in regime shifts, or jumps in spread widening.

A closeup of the above larger scale scatter is given, which gives greater detail:

It is very likely that BB credit spreads, unless long dated volatility of the Russell 2000 drops again to levels of 2017, will surge wider. This may surprise as it can occur while the Russell 2000 is trading upwards. It is obvious an ex post Altman or Graham Dodd type of credit analysis does little to anticipate or provide prescience for key credit spread moves.