We can give three simple reasons to support the use of volatility products to hedge tail risk in fixed income portfolios. First, equity volatility and bond prices have a strong conceptual link. If you think of a corporate bond as functionally equivalent to a risk-free asset (like a Treasury bond) plus a short put option on the issuer’s assets, then the additional yield you receive above the Treasury rate (a.k.a., credit spread) can be thought of as compensation for the sale of that put option. When equity market volatility jumps drastically (as it does during a tail-risk event), the implicit liability from the short put position increases in probability. In a nutshell, the value of bonds will fall as market volatility (yes, even equity market volatility) rises.
Second, you can use highly liquid futures contracts on a volatility index like the VIX (a measure of the implied volatility for options on the S&P 500 Index) to hedge against jumps in market risk.
Finally, there’s a strong empirical correlation between equity volatility and credit spreads. Chart 1 below shows how closely the level of high yield credit spreads (blue line) track the VIX index (red line).
CHART 1: CLICK FOR DETAIL
Source: Bloomberg, using the Barclays High Yield Index and the VIX: Aug 1998 through July 2013
That’s all well and good, but a problem does arise with this type of tail risk-hedging strategy. Because you are taking a long position on the VIX by buying VIX futures, and because VIX futures are generally greater than the actual VIX, this is a strategy to continuously buy a hedge at a high price and sell at a low price. We call this “negative roll yield” and it’s especially efficient…if your goal is to lose money.
Chart 2 below shows the cumulative total return from a program of continuously maintaining a constant long 30-day exposure to VIX futures. Essentially, the shaded area below the main horizontal line is the magnitude of the negative roll yield each day. In fact, an initial US$100,000 allocated to a continuous long exposure to the VIX index through the use of front-month VIX futures would have fallen to less than US$2,000 during the Dec 2005 – July 2013 period as shown in the chart.
CHART 2: CLICK FOR DETAIL
Source: Bloomberg, using *SPVXSP index Dec 21, 2005 through July 31, 2013
To avoid the severe negative roll yield illustrated in the two charts above and yet maintain a hedge against systemic risk events, Principal Global Fixed Income has designed a custom VIX futures-based hedge strategy as a hedge against tail risk. The strategy dynamically rebalances along the VIX futures term structure to hedge tail risk as well as to mitigate the negative roll yield. As you can see in the chart below, the strategy has maintained a generally positive roll yield (shaded area above the 0% axis). This benefits the effect of this hedge to the portfolio. If you’re interested, you can actually track our hedge through Bloomberg. The ticker is BEFSPVAE.
CHART 3: CLICK FOR DETAIL
*Principal Custom index (based upon SPVXSP and SPVXMP Bloomberg data with customized weights) Dec 21, 2005 through July 31, 2013
VIX futures are among the most volatile futures contracts. An investor’s exposure to its index will subject the investor to greater volatility than investments in fixed income securities. The risk of investment losses in trading in futures can be substantial. You should therefore carefully consider whether such trading strategy is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in this trading can work for or against the investor. Futures can utilize leverage. The use of leverage can lead to large investment losses as well as gains.
Principal Global Investors, LLC (PGI) is registered with the U.S. Commodity Futures Trading Commission (CFTC) as a commodity trading advisor (CTA) and is a member of the National Futures Association (NFA). PGI advises qualified eligible persons (QEPs) under CFTC Regulation 4.7.
The information in this article has been derived from sources believed to be accurate. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.
The information in this article contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.
Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions in this article.
Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided.