Rethinking The Role Of Bonds
Derivatives as an Alternative to Fixed-Income Exposure.
- Bonds might be heading for a period of under performance
Income from bonds appears to be dead. Rates are drifting lower for approximately 20yrs. We find that the fixed-income allocation of client portfolios has been targeting longer maturities in order to compensate for the loss of revenue. We are at record duration levels for any kind of theoretically defensive asset we buy for customers. (Today, even structured notes don’t make sense for tenors less than one year).
- Bonds don’t protect like they used to
A mainstream 60/40 portfolio would work in almost any previous crisis, but during the COVID19 market drawdown one would need a 85/15 bond/equity portfolio to protect the equities.
- Higher duration means our bond exposure is riskier
By going further out the maturity curve we are creating portfolios that would take a much smaller change in interest rates to hurt returns if and when rates edge higher.
- What do bonds offer for investors? Income and hedge
Income can be replaced through some kind of short volatility strategies that normally offer a positive carry as long as implied volatility realizes higher than historical volatility in arrears.
Hedge can be replaced with some kind of tail protection (VIX index collars, S&P500 1×2 put spreads, and a few more tactics we can expand on if you have interest). There appear to be multiple alternatives. There are cheap substitutes for anyone who is conservative but believes a meaningful dip (say, >20%) should be bought.
- It’s even worse for credit.
Credit would be a no-brainer. Not only are credit spreads at all-time-lows, but it is pretty simpler to replace. Owing corporate debt is identical to selling a put on equity. When investing in credit you receive a coupon payment, but if the company goes bankrupt you may lose up to 100% of the investment. When you regularly roll a short put option on the same stock, you receive a periodical premium and you also stand to lose 100% of your investment if the company bankrupts.
Furthermore, there are a few advantages to opt for this short volatility strategy to replace credit exposure:
– Credit spreads are at all-time-lows whereas the spread between implied and realized equity volatility remains higher.
– S&P500 is a more diversified index than credit indices, let alone us investing in individual names where the idiosyncratic risk is higher.
– The S&P500 is weighted by market capitalization, hence has more exposure to larger companies (too big to fail?)
– Credit indices are weighted by debt issuance, thus they are biased towards companies with more debt outstanding.
Derivative instruments as a replacement for fixed-income is a novice idea. Although we do not claim we are the originators, KM3 might probably be at the right place in the right time to provide such niche alternatives to its customers. There are a ton of ideas to implement such an investment plan.