Hedging High-Yield and Emerging Market Bond Tail Risk with VIX^® Futures

Abstract

In this article, the authors suggest a different approach to hedging tail risk in certain segments of the fixed-income market. VIX^® futures are based on the implied volatility of equities and therefore are not an obvious choice for hedging the tail risk of bonds. Nevertheless, the authors show that there is a negative correlation between returns for credit-focused bonds and VIX futures, and the strength of the inverse relationship increases during down markets, precisely when the hedge is most needed. This should not be too surprising given that credit risk is positively correlated with equity market risk. In this light, VIX futures, tradable instruments linked to the VIX, become a viable alternative hedging instrument for bonds with significant credit risk. Because there are significant roll costs associated with VIX futures during non-stressed periods, a static hedge will create a drag on returns, but a dynamic hedge can effectively reduce credit-focused bond losses during times of stress.

TOPICS: Fixed income and structured finance, emerging markets, risk management, futures and forward contracts