Opinion Derivatives

It may be worth adding hedges of six-plus months’ duration when spreads trade this tight

Kelley Baum

Credit spreads are close to cycle tights, and credit implied volatility is near cycle lows. When do spreads and volatility indicate that it’s time to add hedges, and when do they indicate that risk is truly subdued and that portfolios should turn to carry for the next phase of returns?

However, it is when carry becomes the focus of returns that forward return expectations are already compressed, so the cost of holding option hedges can be hard to sustain as part of a portfolio striving to reach a target return. So how should you decide whether or not to add hedges in this market environment?

One framework is to evaluate where we are in the credit cycle fundamentally — looking at leverage, profitability and lending standards — to estimate when the cycle could turn. Leverage is relatively high, but starting to improve, indicating that we are in the early part of a recovery, but with rates still at fairly low levels historically, higher leverage may be easy for corporates to maintain.

Profit margins and earnings per share are also in recovery, while lending standards have eased meaningfully and are pointing to late-cycle. Overall this indicates that we are mid-cycle, between a recovery and a boom, and that credit spreads could be at or close to the tights.

Valuations suggest credit is over-valued

Another catalyst for widening seems to be on the horizon. The Fed’s hawkish tilt in mid-June (though it has walked back on statements regarding inflation targeting) frames why widening could occur on a macro level — and an earlier than expected taper could push markets out of their recent stupor.

This cycle has progressed at breakneck speed — with spreads moving from local tights to wides in about one month, and then moving back to the tights in just nine months. Compare that to the cycle surrounding the global financial crisis, where spreads widened for about two years and then tightened for about six. The speed of the current cycle may be indicative of how quickly the boom could turn into another bust.

Historically, it can make sense to semi-systematically add hedges when spreads and volatility get to such compressed levels. Once spreads reach extremely tight levels, especially accompanied by low dispersion and low implied volatility, it’s been hard for the market to sustain those levels for long. In the years since the global financial crisis, once CDX IG has traded below 50 basis points, it has generally sold off by at least 10bp in the next three months. So with the right sizing relative to a portfolio overall, it may be worth adding hedges of six-plus months’ duration when spreads trade this tight.

Cost-effective options and tranche hedges

Lastly, certain tranche trades provide positive convexity and positive roll and carry, with the downside of negative jump-to-default. If you fundamentally believe it’s very unlikely that any IG corporates default, but are cautious about rich valuations, these structures can be very cost-effective portfolio overlays.