Are medium- and long-term bonds the riskiest assets in your clients’ portfolios? With the U.S. stock market setting all-time highs – at least, when measured in terms of the price-weighted Dow Jones industrial average – there is a perception that the U.S. Federal Reserve Board (the Fed) may ease up on the gas pedal, pushing interest rates higher and bond prices lower.
Not wanting to sound like Chicken Little, the Fed has been adamant about downplaying those fears. Based on the minutes from its open-market committee, there is general agreement that rates will remain low well into 2015. But even if that view is correct, it does not necessarily mean that medium- and long-term bonds will remain steady.
Interest rates on medium- (five to 10 years) and longer-term (more than 10 years) bonds tend to move in line with market sentiment, which raises the spectre of duration risk. (Duration is the base calculation that determines how much a bond’s price is likely to move inversely in relation to interest rates, given a one percentage point change in interest rates.) The price of a bond with, say, a 10-year duration is expected to move by 10%, given a one percentage point change in interest rates – and therein lies the risk.
The problem is that bonds also act as a hedge within a diversified portfolio – a kind of crisis insurance that tends to cushion a major sell-off in the equities markets. If you remove that hedge, you should think about a replacement strategy that will perform in much the same way.
That leads us into volatility strategies such as index straddles. We know that volatility moves contrary to equities markets: when markets are rising, volatility contracts; and when markets drop, volatility expands. We also know that volatility is six times more volatile than equities. That means that you do not need to invest a lot of capital in this strategy to hedge a client’s equities exposure.
We also know, based on recent readings in the Chicago Board Options Exchange’s volatility index (symbol: VIX), that volatility now is low, which tells us that options premiums are relatively inexpensive.
These factors make straddles an interesting substitute for the hedging properties inherent in medium- and longer-term bonds. And, given duration risk, straddles also may be less risky than holding medium- and longer-term bonds.
Suppose your client is holding $50,000 in medium-term (seven- to 10-year maturities) to longer-term (greater than 10 years to maturity) bonds. Selling these bonds or fixed-income exchange-traded funds and moving to cash or short-term bonds provides the necessary capital to replace the longer-term fixed-income exposure with a long-term straddle using S&P 500 depositary receipts (symbol: SPY), recently priced at US$155.44.
A straddle involves the purchase of a call and put with the same strike price – buying, say, the SPY March (2014) 155 at-the-money call and the March 155 at-the-money put, for a net cost of US$18.80 each (US$1,880 per straddle) or better. Each SPY March (2014) 155 straddle provides crisis insurance equivalent to approximately US$15,544 (SPY is trading at US$155.44 x 100 shares = US$15,544 exposure) in medium- to longer-term fixed-income securities.
These are one-year options that will be profitable at expiration if SPY closes above US$173.80 or below US$136.20. The straddle also profits if volatility rises, as both the call and the put will be worth more than the initial purchase price.
The theoretical risk is US$1,880, which is the total cost of the straddle. However, this is really a theoretical risk because, for that to happen, SPY would have to close at exactly US$155 at the March 2014 expiration. Moreover, as this is a hedging strategy, you would want to engage in some trading as the market moves up or down to reduce the overall risk in the position.
Using our hypothetical example, in which we sell $50,000 in medium- to longer-term bonds, that equates to being long approximately three SPY March (2014) straddles. The result is US$6,075 invested in one-year straddles, plus approximately $43,925 in cash ($50,000 from the sale of medium- and longer-term bonds minus US$5,540 as a cost for the SPY straddle = approximately $44,250 held in cash, based on the current exchange rate) as our fixed-income crisis insurance.
The advantage with this approach is that your client’s portfolio no longer is exposed to the vagaries of higher interest rates (duration risk) but is still hedged should the market dip. The portfolio also would benefit if equities markets continue to rally because the call side of the straddle will be profitable.
Although nothing is certain, this straddle strategy provides both an alternative to medium- and longer-term fixed-income exposure and a level of comfort in cushioning downside risk.
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