As major stock markets hit record highs, growing numbers of institutional investors are buying long U.S. Treasuries to hedge equity risk. But this comes at a cost: 10-year Treasuries are yielding less than 2%. Fortunately, a more nuanced approach may provide a less costly way to blunt the damage from an equity drawdown, while also potentially improving the risk/return trade-off.
We researched the optimal spot on the yield curve to hedge equity risk with long Treasuries. On average, the “belly” of the curve—around five years—maximizes the diversification benefit relative to a standard 60/40 benchmark portfolio, we found. Moreover, a dynamic swap overlay – positioned along the yield curve to account for carry and the stage of the business cycle—has the potential to deliver sizable Sharpe ratio and drawdown improvements. The details and methodology of our analysis is detailed in “Optimal Yield-Curve Positioning for Multi-Asset Portfolios.”
Finding The Most Effective Hedge
A relatively simple way to analyze hedging effectiveness is to examine every point of the yield curve, scaled by duration, and calculate its hedging beta with respect to the equity market. The lower the beta, the better hedging properties it will provide.
We found that physical bonds with maturities between four and seven years provided the best hedge to equities in our sample period.
If investors use swaps instead, 10-year maturities were the most effective in the U.S., Europe and the U.K. (while the 30-year was the most effective in Japan).
However, this analysis is somewhat limited because it does not account for volatility. To rectify this, we calculated the potential Sharpe ratio improvement from shifting the position along the curve.
Maximizing Return Per Unit Of Risk
To determine which point along the yield curve offers the best returns per unit of risk, PIMCO has long looked at two key measures: carry and roll-down. (Essentially, carry refers to the yield on the portfolio, while roll-down refers to the return earned from “rolling down” the yield curve—when a five-year bond becomes a four-year bond, etc.)
Combined, carry and roll-down refer to the estimated expected return on a bond that results simply from the passage of time. Based only on carry and roll-down, the maximum average return for the benchmark portfolio used in our research is located at the five-year portion of the curve. (We would note, however, that this can shift over time, depending on the steepness or flatness of the yield curve—which, in turn, is driven by the business cycle.) Hence the next part of our analysis takes business cycle dynamics into account.
Incorporating The Business Cycle