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Bond of the Week: 21 June 2013

Bond of the Week: Time For Some Hedging?


The verbal tapering of QE is already creating havoc in the bond markets. Many bond yields broke out of their multi-year bases as investors attempt to ‘front run’ the Fed. Look at the US 5-year bond yield. From a low of 0.7% in April, the yield now changes hands near 1.30% - doubling in just 8 weeks! In the same chart, the green line shows the prices of the 5-year US Treasury future, which, technically speaking, resembles that of a massive long-term top.

The stampede out of the ever-shrinking exit door is unsettling many bond investors.  Will this, investors wonder, mark the end of the multi-decade bull run? Precedent is not on the bulls’ side. Big bases in yields usually last. Compared to the previous rally of 240bps, the current rally is ‘only’ up 60-70bps. Another 100bps advance from here is certainly possible despite Bernanke’s insistence that “our policy is in no way predetermined.”

How will this impact UK bonds? Clearly, UK gilt yields are likely to be dragged up. The overlay chart of the US and UK 10-year bond yield shows a tight correlation. Having breached the 2% level, the 10-year gilt yield is capable of reaching the next resistance at 2.5%. Bonds on lesser credit could be hit ever harder as the ‘hunt for yield’ process unwinds rapidly.

Because of the dimming outlook for bonds, it is time for investors to think about hedging. The broad concept of hedging is to hold a long-only portfolio of bonds but short the market occasionally to benefit from a falling market. For this to work, a few things need to go right. One, the instruments to be shorted must correlate with the underlying portfolio. You don’t want your portfolio to go down and the hedged instruments to go up as you will lose money on both sides.

Two, you want the hedge instruments to go down as much as the portfolio. Anything less will be a very inefficient hedge, meaning the profits from the hedge will be insufficient to cover for the losses in the portfolio. If this occurs, then the hedge must be larger to compensate for the smaller profits.

Three, a hedging program is, ultimately, a ‘trade’. The duration of these short positions is relatively short-term. As such, timing is everything. In a way, it is a tough job to hedge one’s portfolio correctly. In my opinion, perfect hedges only exist on paper.

But with bond prices plunging, is it too late to hedge one’s long-only bond portfolio?

I think not. As the Fed hinted, the tapering may start only in September. The scope for a further decline in the bond market remains high. And, the Financial Times reports today that US bond holders, in just under two weeks, pulled $27 billion out of their funds. Statistics like this may uncork a riot of panic selling. Once in motion, the self-feeding price momentum will be hard to arrest.

Therefore, I would advise readers to consider hedging. Broadly speaking, there are a few ways to do it. One is to buy short-bond ETFs, which benefits from falling bond prices. A potential candidate, first mentioned in Bond of the Week in 2011 (see here), is the db x-trackers II UK Gilts Short Daily ETF (XUGS, link). This instrument is inversely correlated with gilt prices: it goes up when gilts prices fall. By overlaying this instrument and the FTSEORB Index, I note that they do correlate inversely, but not perfectly. Also note that the credit levels of the two sectors are not similar. Gilts are deemed as ‘risk free’ while corporate bonds are usually of a lower credit. This credit mismatch may create cause a divergence in the two instruments. Also, as Mark Glowrey pointed out in his earlier essay: “Just as gilts have an intrinsic rate of return linked to their coupon, the inverse tracker has a corresponding cost-of-carry, factoring in the current steep yield curve, the cost of borrowing bonds and of course management charges (0.25% pa). This is not a "fit and forget" component for a portfolio.”

The other solution is to take a short position in a Sterling-denominated corporate ETF. An example is the iShares Sterling Corporate Bond Fund ETF (SLXX). Again, I overlay this ETF and the FTSEORB Bond Index. They appear to have similar peaks and troughs, which tells me that it could be a reasonably good hedge. A point to consider though:  the average duration of the instruments in the ETF versus your long-only portfolio. According to the website, the duration of this ETF is about 8.66 years.

View: The recent bond price volatility must be creating wild swings in one’s bond portfolio. To smooth these price swings, one may either reduce holdings by selling the underlying, or, take some hedging. I highlight two simple options above. But for more opportunistic investors, the recent sell-offs may be opening up some buying opportunities, especially as bonds approach the 7-8% yield bracket. A quick analysis of the FII website reveals a few bonds above-6.5%, such as the Old Mutual 8% 2021 or the Investec 9.625% 2022.  In conclusion, I think few can predict accurately the impact of the winding of QE later this year, but it most certainly will not be tranquillity.  Opportunities to pick up good bonds, at good prices, are ahead of us. Get ready.

Dr Jackson Wong

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