Hedging Systematic Risk in High Yield Portfolios with a Synthetic Overlay: A Comparative Analysis of Equity Instruments vs. Credit Default Swaps

Abstract

We compare the efficacy of index credit default swaps to a synthetic overlay using equity index futures in hedging the systematic risk of high yield portfolios in the U.S. and Euro markets. Since 2004, the equity overlay was more effective than the swaps in both markets in reducing risk, irrespective of the measure used to represent risk or hedge ratio. While the two instruments exhibited almost the exact same correlation with the high-yield portfolios over the entire period, their behaviors diverged considerably in certain market environments. Credit default swaps mimicked cash market dynamics in calm periods, but during episodes of stress the cash and synthetic high yield markets diverged due to spikes in illiquidity and breakdown of the cash-CDS arbitrage. In contrast, equity futures performed well during such periods, when hedging was most needed.

Despite the improved risk profile of the portfolios hedged with equity futures, deploying the overlay passively resulted in significantly lower performance. To reduce hedging costs, we investigate the benefit of combining equity futures with “writing” OTM put options on the underlying index. We find that hedging the high yield portfolios with a combination of futures and options improved their risk-adjusted performance for a large range of hedge ratios in both markets.

We also examine whether our results change if overlays are deployed on a tactical basis, by representing managers’ skill in making discretionary calls with a simulation framework. We find that for the range of skill levels that can reasonably be expected from a portfolio manager, the combined futures and option overlay continued to dominate the other overlays in terms of both absolute and risk-adjusted performance irrespective of the hedge ratio. Furthermore, we demonstrate that the return predictability of the high-yield market resulting from its relative illiquidity allows even a simple spread-based indicator to be the basis for an active hedging strategy that generates consistent outperformance versus the unhedged index. Deploying the combined futures and options overlay based on this signal increased performance by 1.5% and 2.5% per year on average in the U.S. and Euro markets respectively since 2004 compared with using credit default swaps.