A Different Hedging Tool?

This morning on Bloomberg ETF IQ there was a short conversation about market participants using options on the iShares iBoxx High Yield Corporate Bond ETF (HYG) as hedging instruments. High yield bonds are multi-faceted because they can tell us about a couple of different things depending on what is going on. They can tell us a little about interest rate risk but that isn't the primary story they tell IMO. High yield markets can also tell about credit risk or maybe more correctly perceptions of credit risk, high bonds can at times have equity beta and help as a cyclical indicator. 

If high yield is pro-cyclical and has some equity beta (HYG has had a 0.75 correlation to equities for most of the last two years according to ETF Replay) then could shorting high yield act as an equity hedge? As implied in the first paragraph there are options on HYG and there is also an inverse fund, the ProShares Short High Yield (SJB). I played around with SJB on Portfolio Visualizer and built the following comparison.

 

Portfolio 3 is 100% Vanguard Balanced Index Fund (VBAIX) which is a proxy for a 60/40 portfolio. Blending 75% equity with 25% in some sort of hedge is an example of what I've referred to before leveraging down, trying to get more equity exposure but with a standard deviation that is close to 60/40.

And the results.

 

So there is something to it. The equity/SJB combo lagged the equity/BTAL combo but it had a higher CAGR than VBAIX with essentially the same standard deviation. 

This made me curious about inverse treasuries. Below, Portfolio 1 and 3 are the same, Portfolio 2 I subbed in ProShares Short 20+ Year Treasury ETF (TBF).

 

Using TBF, Portfolio 2 was in line with the others until last year's treasury market carnage when it pulled noticeably ahead. Again, there is something to this but it is not infallible. In 2018 when VBAIX was down 2.82%, Portfolios 1 and 2 were down 3.36% and 3.17% respectively. 

One way to look at this is using inverse fixed income funds "worked" when markets were down a lot in 2022 but not when they were down a little in 2018. That makes intuitive sense to me. If equities are down just a little then it is less likely that there would be some sort of extreme reaction in the bond market be it a flight to safety on the one hand or a credit meltdown on the other.

Think about that last sentence. Stocks could go down a lot and bonds go up a lot, isn't that what is supposed to happen? It didn't last year but yeah, kind of. Since 2012, there wasn't a period of equities down a lot, treasuries up a lot but that is what happened in 2008 and the Internet Bubble.

 

I don't think I would be too eager to use an inverse treasury product to protect against a large equity decline but inverse high yield is more of a maybe. It does have some equity beta and it is usually pro cyclical but there is less direct cause an effect from an inverse equity fund or client holding BTAL. Any sort of hedging product/strategy that might work most of the time cannot be relied on to work every single time which is why I believe in diversifying your diversifiers. I think there might be more things that could get in the way of inverse high yield "working" than with other hedging strategies. 

In the context of diversifying your diversifiers, maybe a smaller allocation to something like inverse high yield would make sense so there is less consequence when it doesn't work. The 25% allocations used in the above hypotheticals were just for expedience in writing this post. BTAL is a client and personal holding and ITOT is owned in some smaller client accounts. I have no intention of using SJB in this context any time soon if ever.