This post is available for download here.
- Last week was a good reminder that there is no ironclad law that rates and equities can’t sell-off at the same time.
- Strategic diversification with bonds is akin to an uncertain insurance policy whose price and ultimate payoff in the event of a market crash is highly dependent on the level and path of interest rates.
- Diversifying your diversifiers with complementary risk management strategies like equity put write, volatility targeted equity, and long/flat equity trend-following has the potential to improve long-term outcomes especially in the event of a bond bear market.
- All three strategies exhibit significantly less interest rate sensitivity relative to a traditional 60/40 stock/bond mix.
The story of last week in the markets was the simultaneous sell-off in equites and rates. The S&P 500 Total Return Index and the Bloomberg Barclays 7-10 Year Treasury Total Return Index ended the week down 0.95% and 1.19%, respectively.
Now, to be clear, the reaction was probably a bit overblown as we remain within 2% of the S&P 500’s all-time high. And while similar joint weekly declines have been relatively rare over the last 20+ years, they are no by no means unheard of. Going back to 1997, the S&P 500 and 7-10 Year Treasuries have both declined more than 1% in 2% of all rolling 5 trading day periods. The most recent occurrences were in late January / early February and late April of this year.
All that being said, it was a good reminder that there is no ironclad law that bonds must diversify stocks. Both can lose – and lose big – at the same time.
As a quick side note, looking at historical drawdowns for U.S. Treasuries in nominal returns is misleading. Historically, the largest nominal drawdown for 10-year Treasuries is around 20%. Certainly painful, but nothing like the downside risk borne when holding equities. The after-inflation picture is much different. The maximum real drawdown exceeds 60%. Equity-like indeed.
The uncertain protection provided by fixed income is exactly why we often advocate for diversifying your diversifiers – blending a number of complementary risk management approaches together. Diversifying your diversifiers can create a portfolio that is more robust to unexpected equity market shocks while delivering higher long-term risk-adjusted returns compared to any single strategy.
Below we plot residual returns for your standard 60/40 S&P 500 / intermediate-term U.S. Treasury portfolio vs. bond returns. The residual returns are the result of regressing monthly returns for the 60/40 portfolio vs. the S&P 500. When we run this regression, we find an intercept of 0.14% and a beta of 0.56.
So as an example, let’s assume that stocks return 5.0% (in excess of the risk-free rate) and the 60/40 portfolio returns 2.0%. The residual return is -0.92% (the difference between the 2.00% actual return and the 2.92% return estimated by the regression (2.0% minus 5.0% * 0.56 + 0.14%). To get a better sense of longer-term risk, we link together the monthly returns to compute rolling 1-year returns.
Obviously, this relationship is strong and positive since the only non-equity source of return in the 60/40 is the 40% allocation to bonds. Even with this 40% allocation, about 95% of the risk is driven by equities, and it is helpful to look at other ways to manage risk, especially with interest rates on the rise.
We repeat this analysis for three additional risk-managed strategies:
We see that the residual returns of each strategy are much less sensitive to bond returns. While the beta of the 60/40 residual returns was 0.56, the beta of the strategy residual returns to bonds is 0.07 for the put write strategy, 0.08 for the 10% volatility targeted strategy, and -0.11 for the long/flat trend following strategy. Furthermore, the r-squared for each regression is less than 0.01.
To be clear, none of the three strategies are immune to rising rates.
All else being equal, put prices will be lower when interest rates are higher. Why? The put buyer has the right to sell the underlying security to the put writer at an agreed upon price. The higher interest rates are, the lower the present value of this payment and therefore the lower the put price.
What does this mean for put write returns? It depends. If the put has already been written, then a subsequent rise in interest rates will lead to mark-to-market gains since the put would have declined in value, a positive for a strategy that is short the put. However, if the option position is held to maturity, then this price movement is just temporary noise and the ultimate profit-and-loss will only depend on the ending stock price and the price the put was initially sold at. In effect, rising rates simply pull some of the gains forward.
In the longer run, higher put prices are good for the put write strategy since more premium is earned for writing the contracts. Therefore, in isolation higher interest rates will generally depress returns since the premium earned will be lower. As an example, consider an at-the-money put on a stock that currently trades at $100. There are 30 days to expiration, volatility is 20%, and the dividend yield on the stock is 0%. When interest rates are at 0%, the price of the put is $2.287. When interest rates are at 5%, the price falls to $2.083. Over the course of a year, this equates to 2.4% less premium earned.
The 10% volatility targeted S&P 500 strategy and the long/flat trend following strategy are both impacted by rate movements because, like the 60/40, they both use fixed income as their defensive allocation option. The advantage these strategies have in a rising rate environment are twofold.
First, when equity risk is low (either measured by low volatility or positive trend), each strategy will generally be over-allocated to equities and under-allocated to bonds, reducing rate exposure.
Second, when equity risk is high (either measured by high volatility or negative trend), the opposite is true. The strategies will be under-allocated to stocks and over-allocated to bonds. In a rising rate environment, the oversized bond allocation can be painful, but may be offset by avoiding a declining stock market in the event that stock losses outweigh bond losses. Furthermore, when there are stock losses, there has historically been a flight-to-safety in bonds that can, at least temporarily, relieve some of the pressure of rising rates.
Note that for both of these strategies, rate sensitivity will depend on what exact instruments are used for the defensive allocation. A long/flat trend following equity strategy that uses cash or short-term Treasuries as the defensive allocation will have less interest rate sensitivity than a similar strategy that allocates to 20+ Year Treasuries when trends turn negative.
At Newfound, we prefer to use shorter duration bonds as our defensive allocation for this reason. There is also a behavioral element behind our thinking on this topic. When you are managing tactical strategies with the goal of downside protection, one of the last things you want is to correctly make the call to de-risk, only to re-allocate to a different asset class that is also losing value simultaneously. Using cash or shorter duration bonds mitigates this risk.
However, it is important to recognize that going this route is not a panacea. As we often say: risk cannot be destroyed, only transformed. The cost of using shorter duration instruments is forgoing earning the term premium (and, potentially, a flight-to-safety premium).
In addition, while cash may be a very safe investment in nominal terms, the reality is that it can experience large drawdowns after accounting for inflation. So, in a rising rate environment that is accompanied by higher inflation, cash may end up having many of the same risks as longer duration securities.
Last week was a good reminder that there is no ironclad law that rates and equities can’t sell-off at the same time. Strategic diversification with bonds is akin to an uncertain insurance policy whose price and ultimate payoff in the event of a market crash is highly dependent on the level and path of interest rates.
The lower rates are today, the more expensive the insurance policy will be in the coming years. Rising rates, while positive in the sense that forward policy prices will be lower, can be painful especially if they coincide with a significant equity market sell-off. This is possible if the macro-economic environment becomes such that our risk mitigator, bonds, becomes sensitive to the same shocks that negatively impact our return generator, stocks.
Fortunately, there are other risk management strategies that are also evidence-based and are not nearly as sensitive to interest rates. Examples include equity put write, volatility targeted equity, and long/flat trend-following. While each of these strategies certainly comes with their own strengths and weaknesses, combining them with traditional asset class diversification has the potential to improve long-term outcomes, especially in the event of a bond bear market.
 CBOE S&P 500 PutWrite Index
 Allocate between S&P 500 and 7-10 Yr. Treasuries based on rolling exponentially weighted volatility. The equity allocation will equal 10% dividend by current volatility. For example, if measured volatility is 7.5%, the equity allocation will be 133%.
 Allocate between S&P 500 and 7-10 Yr. Treasuries using time series momentum with lookbacks ranging from three months to fifteen months. The equity allocation is equal to the proportion of the signals that are positive.
 Again, we can only say this holding all else equal. The stock price at expiration will also have a large impact on results. Say the stock is at $100. If I sell an at-the-money put at $5 and the stock stays at $100 then I make $5. This is preferable to selling the put at $10 and having the stock decline to $50. However, at the time of purchase, we do not know how the stock price will change and here is where the all else being equal comes in. In the same market environment, I’d always prefer to write the put for the highest price possible.