Asymmetric rates of return strategies
“The essence of investment management is risk management, not management of returns.”
– Benjamin Graham.
The global financial crisis in 2008 and the accompanying surge in volatility in many asset classes have reminded that in addition to the investment process aimed at positive returns, the key issue is also a strategy to protect investors’ capital against the risk of portfolio value decline.
Chart: volatility correlation of various asset classes in the years 1996-2011 (shares, Australian dollar, US investment grade companies and debt instruments – emerging markets)
Until March 31, 2011
Historical analysis is not a guarantee of future results.
Stock volatility is represented by the CBOE Volatility Index (VIX), Australian dollar volatility by implied volatility versus AUD/USD, and debt volatility through options-adjusted spreads on the Barclays Capital US corporate index and the Emerging Market Bonds Barclays Capital Index.
Volatility in %, a standard deviation of the rates of return.
Source: Bank of America, Merrill Lynch, Barclays Capital, Bloomberg and Chicago Board Options Exchange.
In portfolio management techniques, you can expect to focus on “asymmetrical return strategies”, investment strategies that maximize growth potential while reducing the risk of decline. The key to such strategies is a robust and dynamic risk management process that limits the likelihood of destructive portfolio losses.
For a traditional long-term investor, alpha – that is, the excess that exceeds the market return (excess market return) – is elusive. Alpha generation is a classic zero-sum game, the profit of one investor is the loss of another investor. And this before taking into account the fees and transaction costs. To consistently outperform the market, it is necessary to gain a competitive advantage in fundamental or quantitative research. In the digital age, when investors have instant access to information, maintaining such an advantage is not a simple task.
What would happen if it were possible to bend the rate profile line so that the investor could use most of the growth potential when the market rises and limit the risk of decline when the market falls?
One way to achieve this and improve the result would be to buy a call option on the underlying asset. A call that gives the buyer the right to buy the asset at a set strike price would keep most of the profits while reducing the maximum loss to the premium paid for the option. Many investments have similar option features and a non-linear return profile. In fixed income markets, this property is known as convexity. Positive convexity is a highly sought after property because a positive convexity strategy has an asymmetrical payout profile – the growth potential is greater than the risk of falling.
Chart: example of a bond with a convexity vs a bond without a convexity:
Left scale: Price, Right scale: level of interest rates
Convexity bond * Non-convexity bond
A simplified example for illustrative purposes.
* Bond convexity is a measure of the non-linear relation of bond prices to interest rate changes, it is the second derivative of the bond price relative to interest rates (the duration of the bond is the first derivative).
The arrows in the chart show the situation respectively: decrease in interest rates (the price of bonds with convexity increases more than the price of bonds without convexity) and increase in interest rates (the price of bonds with convexity decreases less than the price of bonds without convexity).
The search for positive convexity is the foundation for generating asymmetrical return profiles. Such return profiles have traditionally been difficult for an investor with a “buy and hold” option. But for investors who are open to many assets, a global set of options and the use of derivatives, many effective strategies are available. Many of these strategies can be costly. The challenge is how to introduce convexity into investment portfolios at a reasonable cost.
Volatility as a link
Volatility is the common link between asset classes, and returns on these different asset classes can be strongly correlated in times of crisis. There are several reasons for this. First, macroeconomic factors such as interest rates and GDP growth affect the prices of most assets. Changes in market liquidity can also affect many asset classes at the same time, which is particularly evident in crisis situations. Regardless of whether you use a premium in shares or carry interest rate spread between currencies (carry trade), a sharp increase in volatility usually occurs at the expense of returns on the most active strategies.
From a theoretical point of view, the option market provides a link between different asset classes. In the seventies it was proved that equity and corporate credit markets are closely interrelated: risky corporate bond holders can be considered risk-free bond holders who issued put options giving their owners the right to sell capital holders own company at a predetermined price. Holders of shares can be considered holders of the option to buy a value of the firm with an exercise price equal to the nominal value of the company’s debt.
Chart: a common link for equity and corporate debt owners – options:
Source: RCieSolution Research
To put it simply, the theory of options (European-style option) shows that a long position in physical asset can be replicated with a long position in the call option (long call), a short position in the put option (short put) and a cash position (cash). This has important implications: since volatility is highly correlated between asset classes, in some cases investors may “duplicate” assets, combining put and call options with different underlying assets. Looking at the investment world in this context, a wide range of investment opportunities are opening up, enabling you to benefit from price anomalies in various markets.
Chart: Put-Call Parity
Source: Alliance Bernstein, RCieSolution Research
Investors have different utility functions or preferences. In some markets, you can rely on certain players who consistently accept one side of the transaction, for example, US multinational companies operating in Europe wanting to secure their exposure to the euro to reduce the risk of exchange rate fluctuations. Such players can happily pay a premium for options that protect them from adverse exchange rate movements.
Investors, often avoiding risk, are willing to pay high premiums for portfolio insurance offered by put options. For this reason, sale options are more expensive than call options in many markets. Because investors are usually more interested in protecting against short-term events, short-term options are often more expensive than long-term options. All these anomalies can potentially be used by investors with different utility preferences who are willing to take a position on the “other side of the trade.” For example, an investor playing in the future with a worsening business cycle may buy insurance in the form of a long position in cheaper long-term put options before the cycle change.
Various restrictions faced by many large institutional investors (insurers, pension funds), including benchmarks and guidelines for credit rating imposed voluntarily or under regulations, may result in market inefficiency. One of the noteworthy examples are “fallen angels” – bonds that at the time of issue had an investment rating, but were later downgraded by rating agencies to the status of high yield bonds.
Many investors face restrictions on the part of regulators in the area of allocating a significant part of their portfolios to non-investment status debt instruments. For example, insurance companies face restrictions on the amount of high-yield debt they can have in their investment portfolio, as well as stricter capital requirements on part of the portfolio they hold in such bonds. In this way, insurers are subject to strong regulatory pressure to sell bonds that have become fallen angels. After a negative credit event, the prices of investment grade bonds often drop sharply before their official decline to high yields. Since a significant part of the price drop has already taken place at this point, investors forced to sell due to rating restrictions generate significant losses.
Research indicates that after degradation to the territory of junk bonds, fallen angels within the spectrum of credit instruments offer rates of return above average. This anomaly creates opportunities for investors who are not restricted by rating guidelines and are free to buy fallen angels at discounted prices.
Chart: ” Investment grade bonds vs HY bonds vs Fallen Angels
Returns and volatility (%) January 1997 – March 2011
• Return rates • Volatility
Historical analysis is not a guarantee of future results.
Fallen Angels represented by Bank of America Merrill Lynch Fallen Angel Index
Source: BAML Capital Partners, RCieSolution Research
Liquidity and availability of financing
Differences in liquidity and availability of funding can also explain price anomalies between markets. Credit risk should theoretically be valued identically on the cash bond and credit default swap (CDS) markets. It’s not always like that. For various reasons, including the inability to finance positions and investors’ unwillingness to incur losses, some cash bonds have limited liquidity compared to the CDS that applies to the same corporate entity. As a result, the sale of cash bonds may be difficult after a negative credit event. In such cases, the CDS market may become the only way to hedge credit risk. The CDS spreads then tend to be more divergent than the spreads on cash bonds, creating a “positive basis”. *
Conversely, when the level of cash bond issues increases, supply and demand in the market may cause an increase in bond spreads compared to CDS spreads, resulting in a “negative basis”. A negative basis may also arise when funding is limited and some investors liquidate their monetary positions. Should such price discrepancies occur, investors with access to finance can capture the spread between the two markets by buying cash bonds and buying CDS protection (or vice versa), expecting the spread basis to return to normal. This is a classic arbitrage situation in which the investor is not exposed to credit risk, because in the event of the issuer defaulting on its obligations, the long position in credit risk and the position of CDS (short credit risk) offset each other. There are other important risks that should be taken into account in such transactions, in particular the risk that the CDS counterparty will fail (counterparty risk).
* “CDS-bond” basis
The “CDS-bond” basis captures the relative value between a CDS and a cash bond (with similar or identical maturities) of the same credit entity. It is defined as the credit institution’s bond spread subtracted from the CDS spread.
A negative basis means that the spread on the CDS instrument is less than the spread on the bonds and vice versa, a positive basis means that the spread on the CDS is greater than the spread on the cash bond.
The CDS spread (the price of the credit default swap) is expressed in basis points (bp) or in hundredths of a percentage point. For example, if the XYZ CDS spread is 255.5 bp (2.555%), then you need to pay USD 2.555 a year to insure XYZ USD 100 debt.
The use of a positive basis is associated with the sale of cash bonds (spread payment) with the simultaneous sale of protection (receiving a spread) on the same loan. Negative basis trading means buying bonds (receiving a spread) while buying CDS (spread payment) on the same loan.
With the approaching maturity of instruments, the basis should approach zero.
Bond and CDS spreads measure the entity’s credit risk, so theoretically the basis should be zero. In practice, other factors appear, such as liquidity and transaction costs, distorting the baise and causing arbitrage possible.
Theory in practice
For investors who have the skills and experience in recognizing the above types of anomalies, it is often possible to construct investments with attractive, asymmetrical return profiles that maintain significant growth potential while limiting the risk of decline. Unlike typical long strategies, many of these strategies are not directional bets. In addition to the high return potential, such strategies also have low or even negative correlations with broad market indices. While some of these strategies can also be used to generate convexity in typical long-term portfolios, unrestrained investors who have access to a full, multi-asset global set of opportunities and are open to the use of derivatives are best prepared to take advantage of inefficiency and market anomalies.
Short sale of foreign currency
Take the example of a currency that is struggling with fundamental problems, perhaps because of the banking crisis that has raised expectations for interest rate cuts. In this case, the investor could potentially generate attractive returns by short selling the foreign currency. However, in periods of high volatility, this strategy is risky because a sudden reversal of the currency’s downward trend may generate a large loss in the portfolio.
The investor could combine a short position in a foreign currency with a buy option, which would limit the maximum possible loss on the transaction to the premium paid for the collateral (long call). To limit the cost of this collateral, an investor may simultaneously sell a foreign currency put option (short put). In this strategy, known in the terminology of the option as a collar, the premium obtained from the sale of the put option compensates for the premium paid for the purchase of the call option. If the spot price increases, the buy option allows you to buy back a short currency position at the strike price. If the cashier level of the currency fell as expected by the investor, trading would be profitable, although any gains below the put option price would be lost. This results in an attractive asymmetrical structure in which the maximum profit is much greater than the maximum loss. The transaction would be particularly effective if the relative valuation of the call and put option were in the investor’s favor while limiting the cost of collateral. Sometimes this happens when many market players expect an increase in volatility, then put options, which are often used to insure the portfolio, become relatively expensive compared to buy options. Since the strategy is to collect a premium from the sale of the put option while paying a premium for the purchase of the call option, such a market environment would be beneficial for the investor.
Chart: Carry trade short sale strategy using the option collar
• Sale of foreign currency • Sale of foreign currency using the “collar” option strategy
A highly simplified example for illustrative purposes
Source: Alliance Bernstein
Construction of 60/40 bond investment portfolios
One of the very popular strategies in 2009 was buying investment grade corporate bonds. After a massive sell-off, corporate spreads increased by hundreds of basis points and markets priced debt instruments taking into account the default rate at a level considered as unlikely. Investors who bought a credit during a panic were well rewarded after the recovery in the markets.
At that time, low corporate bond prices were accompanied by an abundance of government bonds. Government debt yields were the lowest in history, it was difficult to see the scenario in which the portfolio of corporate bonds with investment rating may perform worse than government bonds. Many investors have noticed the significant potential for return in taking well-diversified positions in investment-grade corporate debt without taking excessive risk. Optimization models, similar among investment managers, given the similarity of currently used risk models, signaled the need to liquidate government bond packages in favor of corporate bonds.
In the investment grade enterprise sector, bond prices were low. In the financial sector, Tier 1 bonds, which are at the more risky end of debt in the spectrum of the bank’s capital structure (we suggest looking at the regulations on bank financing introduced by the Basel III rule in March 2019), were listed at extremely low prices, almost 30 cents for a dollar. These types of bonds were avoided by most investors at that time. They were considered very risky given the ongoing financial turmoil. An investor who invested 40% of his portfolio in these very risky bonds and the rest of his portfolio allocated to expensive US government bonds, could generate a more attractive risk / return profile than a well-diversified portfolio consisting solely of investment grade companies. The 60/40 ratio had a 50% greater growth potential, and in the recovery scenario, the analysis suggested that Tier 1 bond prices would more than double, which would easily compensate for the slight decline in government bond prices. In the “market collapse” scenario, assuming greater financial turmoil, Tier I debt would return just 10 cents per dollar, but Treasuries would probably increase significantly as a result of investors escaping quality, alleviating total portfolio losses. As a result, the risk of portfolio value decline would be slightly different from the risk of a 100% corporate portfolio.
In 2009, the market significantly improved after stabilizing the financial sector. In the recovery scenario that was realized, corporate bonds with investment status were doing well, returning 19%. But the 60/40 portfolio returned 42% – despite US government bonds, which accounted for more than half of the portfolio, they achieved a negative return. This way, by questioning some common assumptions about portfolio management, investors could in this case generate significantly higher rates of return without a significant increase in risk, bending the return profile in their favor. For investors who are able to take short positions and implement derivative strategies, many other strategies are available that generate asymmetrical return profiles.
Transactions using differences in the spread of CDS instruments and bonds
Under normal market conditions, the credit spread of a cash bond usually tracks CDS spreads. However, due to various technical factors, spreads can expand to create attractive opportunities for investors with access to funding. One of the extreme examples of this phenomenon was the situation during the collapse of Lehman Brothers at the end of 2008, when the spreads on both cash bonds and CDS increased significantly, especially in the mortgage and financial sectors.
The spread extension was not synchronized. Due to the wave of downgrades, which resulted in forced sales, spreads on cash bonds increased more than on CDS, creating a negative basis. The availability of financing was limited: banks, hedge funds and other investors were forced to liquidate of their cash bonds and other assets. This had a smaller impact on the CDS market, because unlike cash bonds, CDS are derivatives whose purchase involves a different spending structure than the purchase of cash bonds. Market turmoil has created extremely attractive spread-based transactions. Take the example of a company in distress with a high risk of default in the near future, whose bonds are listed at 50 cents per dollar. Due to the negative basis, the spread on this company’s cash bonds is much wider than the spread on its CDS.
The distressed bond payment profile resembles a call option profile, while the CDS payment profile resembles the protection profile provided by the put option. By combining a cash bond and CDS with the same maturity, the investor could create a very attractive structure whose profile resembles a strategy in option terminology called “straddle” – a combination of call and put options. The “straddle” strategy is associated with the need to incur costs, thereby the possibility of loss in the absence of changes in market prices occurs. However, the recent financial crisis has created rare opportunities for transactions where the expected payout was positive in all scenarios.
Chart: straddle option strategy
A highly simplified example illustrating the profit / loss profile of an investor using the “straddle” strategy (buying a call option and buying a put option)
Source: RCieSolution Research
Regardless of whether the bond turned out to be unpaid and the investor received payment from the protection seller (issuing the CDS), or whether the company fulfilled its obligations and the investor received coupons until the bond maturity, the strategy offered attractive return potential.
Chart: Profit profile of the investor using the straddle strategy (CDS + bond)
A simplified example for illustrative purposes.
Source: Bloomberg, RCieSolution Research.
In other words, investors were able to generate profit from arbitrage if they were able to hold the position to maturity. However, this strategy is not without risk. If investors could not eliminate potential short-term market losses and were forced to reverse their positions before maturity, they could suffer significant losses.
An analysis of investment grade corporate bonds shows many such discrepancies that may be subject to arbitration. Our bond sample comes from Markit iBoxx indices, which include bonds with a specific issue size and type. Since the point on the CDS curve determining the 5-year period is usually the point determining the highest liquidity, therefore for analytical and practical reasons instruments with a five-year maturity should be included.
Dynamic risk management proces
A reliable and active risk management process is an essential element of any strategy, because large losses can have a disastrous impact on long-term returns on investment portfolios.
In addition, as the financial crisis has shown, the market’s downward risk is much greater than one would expect in theory. The basis of modern portfolio theory is the bell-shaped curve that shows the symmetrical “normal distribution” of portfolio returns around the average. In fact, however, the tails of decay are much thicker than what this theory predicts. For example, the daily distribution of exchange returns on the S&P 500 index is more in line with the “T distribution”.
A time-tested method of protecting wallets against losses is diversification. By placing assets with a low or even negative correlation in the portfolio, we can reduce its overall risk. One way to achieve this within one asset class is globalization. Economic cycles and profit trends are not perfectly synchronized between countries, the diversification provided by global equities or bonds may reduce volatility compared to one country’s portfolio. It may also be helpful to add other weakly or negatively correlated asset classes to the portfolio. For example, a portfolio or multi-sector loan portfolio manager may benefit from the fact that returns on sovereign and government bonds were negatively correlated in most historical periods. As risk aversion increases and credit spreads increase, government bonds tend to increase.
To protect against extreme events, the portfolio manager can choose an additional layer of protection and actively protect the wallet by buying protection from jumps in volatility. Volatilities are valued almost uniformly across all asset classes, and portfolio risk can often be reduced by taking a derivative position in another asset class. This technique is known as “macro hedging”.
Of the many derivatives available, we have determined that S&P 500 put options are the most effective and liquid instrument available for dynamic tail risk hedging. To hedge against unlikely tail risk events, investors can buy deep out-of-the-money options to lower protection costs. Other strategies include purchasing CDS in the area of high-quality tranches or currency buying options that may increase as a result of escaping to quality. Such hedges must be closely monitored because changing market conditions may require adjustment of hedge ratios.
Final conclusions from the implementation of asymmetrical return strategies
The recent financial crisis has caused many investors to question some of the key assumptions on which the portfolio management industry is based. In particular, investors pay more attention to the correlation of risky assets during crises and the dangers of a catastrophic “tail risk”. In the coming years, scientists are likely to improve many of the models we use to view the world of investment. Meanwhile, we believe that a key trend in the future of portfolio management will be focusing on generating asymmetrical return profiles – investments that maximize growth potential while reducing the risk of decline.
In our opinion, the key to the success of such strategies is the dynamic risk management process, which limits the likelihood of large losses in the portfolio. Those investors who have access to the full global set of options covering many assets and are open to the use of derivatives are best prepared to take advantage of the inefficiencies and market anomalies.
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.