The Big Idea
Hedging credit spreads
Steven Abrahams | August 12, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Big swings in risk spreads this year and spotty liquidity have made it tougher than usual to run a credit fund. Most managers in a perfect world would get long as spreads tighten and short or into cash as spreads widen. But rebalancing has become expensive. It can also mean chasing suddenly scarce assets as spreads tighten and selling positions hard to find later as spreads widen. Some credit funds have chosen to stay long and manage net risk through more liquid hedges. That strategy looks like it can reduce risk, but only modestly.
A limited set of portfolios can manage their credit risk with market instruments. The Investment Company Act of 1940 limits the ability of mutual funds to get short or use derivatives, so that leaves the active hedging of credit risk, naturally, to hedge funds.
Hedge funds can use single-name or basket default swaps, but there’s also potentially something to gain from other instruments. Credit spreads should depend on equity prices since more equity cushions debtholders and less equity puts them at more risk. That brings short positions in equity or in equity derivatives into the hedging mix. Credit spreads should also depend on the outlook for the economy, which may only partially get reflected in equity. The slope of the yield curve can reflect views of future strength or weakness in the economy, so that brings short positions in rates or rate derivatives into the mix, too. The changing price of liquidity can make a difference, too, and although there are not obvious hedges for liquidity, it is important to consider it.
Based on quick analysis of spreads in a basket of corporate investment grade cash bonds and in a basket of high yield cash bonds, relatively simple hedges show a material although modest ability to offset spread volatility (Exhibit 1).
Exhibit 1: Quick analysis of simple hedges for cash corporate spreads
Taking daily changes in the Bloomberg index of investment grade cash spreads (USOAIGTO) and regressing them on daily changes in the simplest hedge, the Markit CDX North American Investment Grade Index, a 1 bp change in the hedge offsets an average of only 0.57 bp of cash spreads. Just as importantly, using only the CDX reduces total spread risk by only 23%, the rest coming from other sources such as differences between the composition of the cash and CDX baskets and other factors. Regressing daily changes in cash spreads on daily changes in the CDX, the slope of the 2s10s curve, the S&P 500 index and a measure of Treasury market liquidity also shows at best modest results. Only the CDX, the S&P and liquidity register as significant, and the total reduction in spread risk only climbs to 25%. The extra reduction is risk may not be worth the complexity of the added hedges.
Results are better for daily changes in the Bloomberg index of high yield cash spreads (USOHHYTO). Regressing those changes on daily changes in the Markit CDX North American High Yield Index shows a 1 bp change in the hedge on average offsets 0.45 bp of cash spreads. Spread risk is now reduced through hedging by 40%, a big improvement from the investment grade hedge. Adding the 2s10s curve, the S&P 500 index and Treasury liquidity to the hedge again registers only the CDX, the S&P and liquidity as important, and total spread risk drops by 42%. Again, the complexity may not be worth it.
There may be more effective although more complex ways to hedge credit spread risk than using the most liquid market instruments, but with complexity usually comes cost at least in rebalancing. At a certain point, paying the cost to rebalancing a credit portfolio may be more manageable than rebalancing a complex portfolio of hedges. Managers may simply want to buy some type of disaster insurance—one or more out-of-the-money put options on the S&P or similar options on wider spreads—and leave it at that.
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The view in rates
The 2-year note closed Friday at 3.24%, only a basis point higher than where it stood a week ago. It still looks rich. The 10-year note looks like it is in the neighborhood of fair value at 2.83%. The 2-year rate should approach 3.50% assuming a Fed more concerned about inflation than recession. Fair value at 10-year and longer maturities still looks solidly in the neighborhood of 2.50%, but the possibility of a sustained fight with inflation may require compensation above fair value even in long maturities. The 2s10s curve looks likely to invert by around 70 bp before Fed tightening is over.
Fed RRP balances closed Friday at $2.21 trillion, roughly the average since mid-June. Yields on Treasury bills out to early October continue to trade below the current 2.30% rate on RRP cash. Money market funds have little alternative but to put proceeds into RRP.
Settings on 3-month LIBOR have closed Friday at 290 bp, wider on the week by 4 bp. Setting on 3-month term SOFR closed Friday at 271 bp, wider by 9 bp.
The 10-year note has finished the most recent session around 2.83%, unchanged on the week. Breakeven 10-year inflation finished the week at 247 bp, also unchanged from a week before. The 10-year real rate finished the week at 35 bp, also unchanged for a 10-year trifecta.
The Treasury yield curve has finished its most recent session with 2s10s at -41 bp, inverted another 1 bp on the week. The 5s30s finished the most recent session at 15 bp, steeper by 4 bp on the week.
The view in spreads
The disconnect between Fed rhetoric on continued tightening and the easier path of fed funds implied in forward rates will have to be corrected, and that promises another round of volatility later in the year. In the meantime, volatility is coming down and spread markets are liking it. Both MBS and credit have tightened steadily since July. MBS has outperformed credit, although it looks tactically rich. As the Fed tightens and growth slows, MBS should continue outperforming. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields finished the most recent session at 114 bp, tighter by 10 bp on the week. MBS OAS, on the other hand, continues to slowly tighten, suggesting good net demand. Par 30-year MBS OAS finished the week at 6 bp, tighter by 6 bp on the week. Investment grade cash credit spreads have also tightened on the week by 10 bp.
The view in credit
Credit fundamentals have started to soften with the weakest credits showing slower revenue growth so far in 2022, declining free operating cash flow and less cash on the balance sheet. In many quarters, the conversation has turned from whether recession will arrive to the shape of recession once it does. It will be important to watch inflation and see if costs begin to catch up with revenues. A recent New York Fed study argues inflation generally helps companies lift gross margins. A higher real cost of funds would start to eat away at highly leveraged balance sheets with weak or volatile revenues. Consumer balance sheets look strong with rising income, substantial savings and big gains in real estate and investment portfolios. Homeowner equity jumped by $3.5 trillion in 2021, and mortgage delinquencies have dropped to a record low. But inflation and recession could take a toll and add credit risk to consumer balance sheets.