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Cross-asset hedging – Credit ‘puts’

August 2021

High yield credit investment products such as HYG (a US high yield ETF) and CDX HY (the US high yield CDS Index) have consistently sold off in tandem with equities in the past, so ‘puts’ on those assets can reliably be used to hedge underlying equity exposure. Our analysis suggests the combination of tight spreads and low implied volatility makes credit ‘puts’ an attractive proxy hedge, when benchmarked against the cost of direct equity protection.

Hedging equity risk with credit ‘puts’

Unprecedented policy support has caused credit spreads to more than fully unwind COVID induced widening. For example, US High Yield spreads are currently sitting around the 7th percentile for the last 20 years. Policy support has also led to low levels of implied volatility for credit, with normalised vol for CDX HY spread sitting around 115bp/yr – around the 20th percentile for since index vol started trading in 2007 – compared to crisis-level vols of around 700bp/yr back in March 20201.

Our analysis suggests the combination of tight spreads and low implied volatility makes credit ‘puts’ an attractive proxy hedge. The chart below shows S&P 500 and CDX HY, with drawdown or ‘stress’ periods highlighted in red2. In each of the 11 highlighted stress periods since 2005 high yield has participated in the sell-off. The degree of participation has varied somewhat, but the direction is consistent, so we view HY credit hedges as a reliable proxy for equity hedges.

The table below shows the change in S&P 500, HYG and CDX HY for each of the stress periods highlighted above. We focus on these two securities because there are (relatively) liquid options markets available to trade on them. On average, HYG and CDX HY have a ‘Stress Sensitivity’ of 0.56 and 0.469 respectively. This means, for example, that on average during stress periods, HYG sells off 5.6% for each 10% decline in S&P 500.

Based on the above we would expect HYG and CDX HY hedges to cost 0.56x and 0.469x equivalent S&P 500 hedges. When hedging we care about limiting large drawdowns, rather than hedging against every tick down in the market, so on that premise we compare ~25 delta options below3. Normalising the option prices for each by the Stress Sensitivity gives us an option ‘Price per unit Stress’ which we can use to compare cross-asset proxy hedges. On this metric, US HY hedges screen favourably compared to simple S&P 500 puts, so look attractive to us as a way of hedging equity exposure.

The Solutions Team

The Solutions team provides derivative overlay and risk management fiduciary services to Asset Owners and Managers in Australia. Our goal is to provide asset owners and managers with an experienced overlay advisory and execution service to improve portfolio outcomes and cost efficiency.

1 Fixed income volatility is often expressed in terms of absolute ‘basis point’ moves rather than percentage of price, reflecting market practice of thinking about absolute changes in yield/spread for fixed income securities/indices.
2 We define a stress period as a 10% or greater drawdown in a 3 month or shorter window.
3 We compare ~3 month expiry and ~25 delta based on the available CDX HY options.

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