Using leveraged short ETPs to hedge fixed income amid ECB QE tapering

Jan 25th, 2018 | By | Category: Fixed Income

By Viktor Nossek, director of research at WisdomTree in Europe.

Viktor Nossek, director of research at WisdomTree in Europe.

Viktor Nossek, director of research at WisdomTree in Europe.

Leveraged short ETPs that track Bunds can serve as capital-efficient hedging tools for investors seeking to protect their European high-grade bond portfolios in rising interest rate scenarios. The usefulness of such ETPs is particularly relevant in the current environment, with the European Central Bank (ECB) recently announcing that it will begin tapering its quantitative easing (QE) programme. Credit markets are slowly adjusting back to policy normalisation.

This blog showcases how leveraged short ETPs tracking 10Y German Bunds perform as hedging instruments for high-grade European government and corporate bonds.

Hedging government bonds with leveraged short ETPs

The following example illustrates how beta hedging can extract greater capital efficiency out of leveraged short ETPs tracking high-grade fixed income.

We used two leveraged short ETPs as hedge instruments, each with a different leverage factor. These were:

  • Boost Bund 10Y 3x Daily Short ETP (3BUS LN); index’s duration = -9.5
  • Boost Bund 10Y 5x Daily Short ETP (5BUS LN); index’s duration = -9.5

The holding period of the hedge was four weeks. The investment to be hedged was a portfolio of high-grade European government bonds; benchmark = Bloomberg Barclays Germany Gov. 7-10Y Index; duration = 8.2

Based on daily analysis of the four-week returns from which the betas for the 3x and 5x short ETPs vs the portfolio’s benchmark were calculated, the following observations were made (see Chart 1):

Source: WisdomTree.

  • The 3x short ETP and the 5x short ETP tracking the 10Y German Bund had betas of -3.2 and -5.3 respectively, versus the portfolio’s benchmark of 7-10Y German government bonds.
  • Based on the betas, the initial capital outlays to hedge the portfolio for approximately a month were 31% and 19%, respectively. This was roughly equal, if not slightly less than, what was implied by their respective leverage factors of 3x (33% of the portfolio) and 5x (20% of the portfolio).
  • The difference in interest rate sensitivity between the portfolio’s benchmark and the leveraged short ETPs determined the extent to which investors could further ‘lever-up’ or ‘lever-down’ their hedged position. Given the 10Y German Bunds’ duration of 9.5 was higher than the 7-10Y German government bond portfolio benchmark’s duration of 8.2, investors effectively assumed ‘additional beta’ (approx. +0.2 when using the 3x short ETP, +0.3 when using the 5x short ETP as a hedging instrument) on top of the leverage factor.
  • The higher leverage factor did not undermine the reliability of using beta to approximate the initial capital needed to hedge the portfolio, with a comparable high goodness of linear fit for both the 5x and 3x leveraged hedge constructs. The very low volatility of high-grade fixed-income assets (which minimises the daily compounding impact on their returns), reinforced the usefulness of having high leverage factors accompany ETPs tracking benchmarks such as 10Y German Bunds.
  • There was noticeable convexity in the performance of leveraged short ETPs to large price changes in the portfolio’s benchmark. This suggests that in extreme market conditions, if bond prices fall, investors are likely to be rewarded with a performance boost to the net exposure (i.e. the percentage gain in notional value of the short position will exceed the percentage loss in market value of the long position). In contrast, if bond prices rise, there is likely to be less of a performance drag to the net position (i.e. the percentage loss in notional value of the short position will fall short of the percentage gain in market value of the long position).
  • In summary, the 3x and 5x short ETPs tracking 10Y Bunds acted as efficient hedging tools for European government bonds.

Hedging corporate bonds with leveraged short ETPs

Will leveraged short ETPs tracking government bond benchmarks work as capital-efficient hedging instruments for corporate bond portfolios? It depends on market conditions.

Hedge overlays using high-grade government bond benchmarks such as 10Y German Bunds are likely to perform poorly in abnormal market conditions. This was illustrated during the Global Financial Crisis and more recently, in the face of ultra-loose monetary policy. Frequently, central banks’ exceptional open-ended support for government bonds in response to financial uncertainty trumped the fundamental arguments of ‘runaway inflation’ and ‘higher yields’ for shorting German government bonds. German government bond yields have essentially trended in one direction only: down.

De-correlating prices between corporate and government bonds further complicate hedge structures with shorts that use government bonds as the underlying. Consider the ECB’s sterilised interventions in select bond markets in 2010 (Security Markets Programme) and 2012 (Outright Monetary Transactions) which, in conjunction with zero interest rates and cheap term loans, primarily supported covered (mainly mortgage backed) bank bonds and, indirectly, sovereign bonds on a large scale. The exclusion of high-grade, non-financial corporate issuers from bond-buying programmes forced corporate spreads to widen sharply, as the lack of liquidity undermined price discovery and instigated a decoupling in even the high-grade segments of the bond market (see Chart 2).

Epitomising the distortions caused by ultra-loose monetary policy was the degree to which investors took on more term risk to chase government yields to the floor and into negative territory, following the ECB’s announcement of its QE launch in 2015. This initially widened corporate spreads, until QE was expanded to include corporate bonds in 2016 and the widening of spreads reversed. With the whole bond market on artificial support and interest rates falling, hedging Eurozone interest rate risk was—within high grade—effectively unnecessary for long-only investors.

When corporates decouple from government bonds to a large extent and move in the opposite direction, setting up hedges using government bond benchmarks as the short’s underlying will be ineffective. Investors must therefore carefully assess market conditions before deciding if and when a short government bond benchmark exposure will behave in line with both the underlying fundamentals and the portfolio.

Source: WisdomTree.

Most effective in a rising rate environment

The purpose of hedging with leveraged short ETPs that track government bond benchmarks is to neutralise duration risk. Credit risk, explicitly, is not captured. However, assuming government and corporate bonds are generally moving in the same direction (with different magnitudes), in normal market conditions, varying credit spreads will generally not reduce the effectiveness of hedging a corporate bond portfolio with leveraged short ETPs tracking government bonds.

To showcase how leveraged short ETPs tracking 10Y German Bunds could effectively hedge a corporate bond portfolio under normal market conditions, we present the following example:

The leveraged short ETP used as a hedge instrument:

  • Boost Bund 10Y 3x Daily Short ETP (3BUS LN); index’s duration = -9.5

The holding period of the hedge was four weeks.

The fixed-income investment to be hedged:

  • A portfolio of Euro corporate bonds; benchmark = IBOXX Euro Corporates Index; duration = 5.3

We compared the hedge instrument’s effectiveness in normal vs abnormal market conditions, loosely defined as:

  • 2006 – 2007: normal market conditions subject to monetary policy tightening and rising rates expectations
  • 2008 – 2017: abnormal market conditions with exceptional stimulus and ultra-loose monetary policy

Based on daily analysis of the four-week returns, the beta readings suggested the following (see Chart 3):

Source: WisdomTree.

  • The beta of the 3x short ETP tracking 10Y German Bunds to the Euro corporate bonds portfolio was 4.9 for the 2006 to 2007 period during which the ECB increased interest rates by 175 bps. Setting up the initial hedge on the basis of beta should have, in the first instance, improved capital efficiency by more than the leverage factor implied, mainly due to the large duration mismatch between the leveraged short ETP’s underlying and the portfolio’s benchmark.
  • The beta was relatively robust during this period of rising interest rates, with the four-week returns of the 3x short ETP tracking 10Y German Bunds explaining approximately 67% of the variance in the four-week returns of the Euro corporate bonds.
  • While a hedge will not be perfect when using inverse government bond exposures as hedge overlays for corporate bonds, an offset position created with the leveraged short ETP and held for approximately a month may cancel out the majority of the interest rate risk within the corporate bond portfolio. This is due to the tendency of government and corporate bonds to move in lockstep during tightening monetary conditions.
  • To maintain the hedged position and control volatility, rebalancing the hedged exposure may be necessary in a rising rate backdrop, when, amidst increased risk-taking behaviour, corporate spreads narrow and short positions could be added (i.e. buying leveraged short ETPs). Rebalancing may also be necessary amidst increased risk-averse behaviour when corporate spreads widen and short positions could be cut (i.e. selling leveraged short ETPs). Such adjustments to the hedged position may need to be more frequent when price volatility increases and correlations between government and corporate bonds weaken, as is evident from some of the scatterplot’s outliers in Chart 3.
  • When fear took hold at the height of the Global Financial Crisis, safe-haven assets were highly sought after. Needless to say, the frequent occurrence of inverse movements between 10Y German Bunds and Euro corporate bonds meant a short position in 10Y Bunds would have failed as a hedge overlay. Rather than reduce the risk, in many instances this type of hedge would have subjected the investor to increased volatility and higher downside risk. Frequent rebalancing of the hedged exposure could have reduced the volatility and downside risk, but at the price of accruing relatively large transaction costs, which would have defeated the beta-hedging strategy’s purpose of capital efficiency.

Inflection point on the horizon

Finally, managing the hedged position is key in an environment where monetary policy is still exceptionally loose and high-grade debt valuations remain close to historic highs relative to other asset classes and the fundamentals underpinning them. As we approach an extraordinary stimulus inflection point in the Eurozone, following the ECB’s announcement in October 2017 that it intends to taper QE, Europe’s high-grade bonds may experience increased price volatility. Last year’s negative to near-zero yield period for Germany triggered a sharp sell-off.

Consequently, investors that have allocated to high-grade bonds and the term risk associated with obtaining a positive yield, risk being disproportionately exposed to policy normalisation. These investors should consider the very low coupon yields at which many long-dated issues currently trade on secondary markets and the convexity assumed.

Against Europe’s rising interest rate backdrop, leveraged short ETPs tracking Bunds may serve as effective interest rate risk hedging tools.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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