Hedging Corporate Bonds with Stock Index Futures

Abstract

When investing in corporate bonds, investors face credit as well as interest rate risk. Conventional wisdom suggests that we should hedge interest rate risk with Treasury futures contracts and to hedge credit risk with S&P futures. In this study we use a variety of instruments to hedge portfolios of U.S. corporate bonds, formed on the basis of both maturity and credit rating. Using these portfolios we are unable to demonstrate that a Treasury plus S&P futures hedge performs any better than simply hedging with Treasury futures alone. Furthermore, when we explore the effectiveness of three alternative dual asset hedging strategies, we find that only for low credit quality, long-term corporate bond portfolios can any of these alternative hedging strategies be more effective than simply hedging interest rate risk alone. The moral of the story is clear. Credit risk is difficult to hedge, and unless the bond portfolio consists of long-term, low credit quality bonds, we may be better off not trying to hedge credit risk at all.