IS IT WISE TO HEDGE CREDIT EXPOSURES WITH EQUITY INDEX FUTURES? When equity and high-yield bonds are in bull markets, hedging against a potential downside is costly. Indeed, anyone who hedged either stocks or high- yield bonds would have missed out on gains over the past decade. However, bull markets unfortunately don’t last forever. As the current bull market in equities and bonds ages, volatility has begun to rise in both markets and the risk of a bear market might be growing. This, in turn, increases the temptation, or even the necessity, of hedging downside exposure.
Although the S&P 500® and the Bloomberg Barclays US Corporate High Yield Index are not perfectly correlated, their drawdowns tend to coincide with one another (Figure 5). Since 2002, nearly every sharp selloff in stocks has coincided with a significant downward move in the price of high-yield corporate bonds.
Moreover, the day-to-day correlation between the S&P 500® and measures of corporate bond performance has also risen over the years, perhaps, in part, because corporate bond markets became somewhat more liquid (meaning a greater frequency of trading) between 1999 and 2009. Over the past few years the equity-high yield bond correlation has often been in the 0.40-0.60 range (Figure 6), meaning that one could plausibly hedge corporate bond exposure using equity index futures – although not without potentially significant tracking risk. Finally, in the past 12 months that correlation has been at its highest point ever: +0.75 when measured daily over the past 260 trading sessions.
When hedging corporate bond exposures using futures or options, timing is everything. While our research suggests that a flat yield curve may be increasing the likelihood of a sharp sell off in lower- rated corporate bonds, hedging that risk with equity index futures can be tricky. In the late stages of an equity bull market, stocks often rally even as high- yield spreads widen. This was the case in the late 1990s (Figure 7) and between February and October 2007 (Figure 8). It appears to be the case once again in the last few months (Figure 9).
Figure 5: Sharp Declines in Stocks Often Coincide with Sharp Declines in Corporate Bonds.
Source: Bloomberg Professional (LF98TRUU and SP1)
Figure 6: A Rising but Still Imperfect Correlation Between Stocks and High-Yield Bonds.
Source: Bloomberg Professional (LF98TRUU and SP1)
Figure 7: Credit Spreads Began to Widen Three Years Ahead of the 2000 Peak.
Source: Bloomberg Professional (SPX and LF98OAS)
26 | ADMISI - The Ghost In The Machine | September/October 2019
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