Current news releases related to fixed-income investments are filled with predictions that the 30-year bull market for bonds has ended. Bill Gross of Pimco has recently announced that he has no exposure to government securities, and other industry periodicals are reporting that financial advisors are reducing or eliminating client exposure to bonds.
But following the lead of bond managers may not be the right strategy for many financial advisors. Bond fund managers are constantly searching for bonds to acquire and adjust their portfolios to produce equity-like returns on a quarterly basis. In contrast, the held-to-maturity bond portfolio is designed to meet specific needs that are not met with bond mutual funds or fixed income ETFs, which always hold bonds with predetermined target maturities.
Individual bonds pay their full face value at maturity, a unique property that has many applications for financial planning. Using individual bonds to meet a client's specific and quantifiable future capital needs can be a prudent choice.
A downside of bonds is that their prices are inversely affected by current interest rates. But a portfolio of individual bonds can be protected with futures contracts, which can maintain the value of the holdings during periods of anticipated and continuing rising interest rates. Futures contracts come with a set of features and limitations that set this strategy apart from some other possibilities, such as buying and selling bonds or purchasing put options on the bonds.
Replacing bonds in a portfolio results in transactional and bid/ask costs that erode returns, and the new bonds may not provide cash flow to meet future liabilities or expenditures. Purchasing put options on the bonds is an expensive form of insurance for a number of reasons. Options are a wasting asset and have a defined expiration date. The coverage of an option is also restricted to the strike price of a put option purchased in relation to the underlying asset market price at the time of opening the position. A put option with a strike price equal to the underlying bond will not move in value when the underlying bond price changes at the same rate. This is observed by the option metric known as delta. Usually options that are "at the money" have delta of approximately 0.5. This means that for each dollar the underlying asset moves in value, the option value will change by approximately one-half-dollar. Only in extreme price movements may the purchasing of puts be profitable.
A futures contract is a highly leveraged trade agreement that specifies the delivery of a standardized quantity and quality of an asset. In this discussion, bonds are the asset. A futures contract position is held by maintaining a cash deposit with a Futures Commission Merchant, which is subject to daily changes in value as a result of changes in value of the underlying instrument. A hedging account has the lowest initial margin requirement because of the holdings in the cash market. This margin deposit requirement is approximately 1% of the notional value of a Treasury-bond futures contract. The daily changes in the value of the contract are adjusted between the opposing holders of the contract. For each long-position holder there is a short-position holder. Hedging a bond portfolio with futures contracts will be done by holding short positions. The performance of the hedge is based on the changes in value of both the futures account and the bond portfolio. When the hedging program is balanced, the gains/losses in the cash holdings will be offset by the losses/gains in the futures account resulting in a net constant value.
Calculating the number of futures contracts needed to hedge a bond portfolio is far more involved than matching a contract to bond on a notional value to a par value method. CME Group, through its Chicago exchanges, facilitates the trading of futures on U.S. Treasury obligations. Contracts are available on T-Bill, 2-year and 5-year notes, 10-year bonds, and 30-year bonds. Options on these contracts are also traded.
CME Group recommends a duration matching strategy of futures to the bond portfolio. This may work well when the holdings in the portfolio are issues of the U.S. Treasury. Duration is defined as how a portfolio of bonds behaves in price change when interest rates change. Higher duration values correspond with longer term maturities.
This approach does not consider a portfolio of varying bonds. A custom approach to consider the credit quality, imbedded options, issuer, maturity and other factors that are attached with each bond on the overall portfolio will be essential in determining the appropriate choice of which contract to use as well as the number of contracts. Another consideration is to determine how each of these bonds have behaved in the past when interest rates change and allow the determination of the beta of each bond, for further integration into the beta of the portfolio.
Hedging a bond portfolio does exchange the risk of price change due to market conditions for basis risk. Basis risk is the difference between the futures contract entry price and the price in the cash market. Futures contract on U.S. Treasuries have expiration dates regularly established on a March, June, September and December cycle, usually around the 20th of each month. Each subsequent futures contract has a lower price than the one before it. This represents the risk premium in purchasing the asset at progressively further future dates, describe by John Maynard Keynes as backwardation. As time approaches the expiration of a given futures contract, the price difference between the futures contract and the cash market decreased. At expiration convergence of the price differentials occurs. A hedger that is short futures contract will be subject to the loss of basis difference and this may result in an additional cost of hedging, noticed when rollover futures positions from a soon-to-expire contract to the next in the series that has life remaining.