New Long-Credit / Hedged-Rates Products Hazardous

A popular trend in the fixed-income world is the creation of products which provide exposure to fixed-income generally, without exposing investors to the risk they consider the most concerning: interest rate risk.  The story goes that “yields can’t go much lower” and bonds have been in a 30 year bull market that has to end at some point.  So, products have been created which generate income but hedge off interest rate exposure with short positions in treasuries or similarly high quality securities.

This is a disaster waiting to happen. 

First, let’s address what the net position created actually is.  If you are long credit, you do have an income generating asset, but you also have a proxy for equity exposure.  High yield bonds are much more highly correlated with equities than they are with their IG fixed-income counterparts, and so an “equity junior” position of sorts has been established. 

Next, layer on a position that is short the only traditional asset that provides negative correlation to equities in retail portfolios.  By trying to create a pure interest rate risk hedge via treasuries, these products are adding the equivalent of more net long equity exposure (if there is a marked equity decline, treasuries historically rally due to their safe haven reputation).  So this “hedged” product has two components: one that is long an equity proxy, and another that is short the only asset negatively correlated to equities. 

1 Equity – (-1) Equity = 2 Equities, right?

So how can these products masquerade as fixed-income (read: low-risk) investments?  Financial engineering at its worst, these new funds are preparing the most conservative part of client portfolios for the most volatile experience.

The case for these products is often that, with low rates and easy credit, the higher yields in these HY Corporates are safe bets from a credit-risk standpoint.  The one “real” concern is that the Fed is going to hike rates, and of course that will decimate treasury notes or anything without a sufficient credit cushion.  So, according to the sellers of these funds, invest with a long-equity footing in fixed-income, complemented by shorting an anti-equity position.  Or simply, double down on equities for the diversifying, lower-risk part of a client’s portfolio.

So what happens if credit spreads widen, equities pull back and investors globally rush into the safe-haven of last resort, US Government Bonds?  Well, first, as credit spreads blow out, the risk taking portion of these funds will get hammered.  Then, to complement, treasuries will rally as a result of massive global inflows, and the “interest rate hedge” will work against the portfolio doubly. 

A reason to short quality, it is claimed, is that treasury rates have a zero bound.  I suggest a counterpoint: Swiss debt has negative yields out to ten years, and Dutch mortgage rates are negative!  It is clear that the Fed has deprived investors and their trusted advisors of accessible yield, but chasing it this far does not seem prudent.

Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes.