Friday, September 18th, 2020

How to Hedge an Equity Sell-Off

Ever since the since the first asset allocation text book was written, the fundamental idea behind all the theoretical models is that when equities go down, government bonds will go up. If this relationship stops working, most balanced portfolios are in deep trouble. And yet that is exactly what our data suggest is already happening in the key 7-10 year maturity. Even if the relationship continues to work for longer maturities, it covers a much smaller part of the total bond universe than investors were previously able to rely on.

There are two ways of approaching this issue, the first is to look at current nominal yields to maturity and speculate how deeply negative they could go in a period of crisis. The problem with this approach is that it requires investors to make a big call about inflation over the next most of the time. The only scenario in which the offset could work is one of massive deflation. If it works in the next bear market, it can only do so by driving nominal yields so negative that they guarantee its failure in any subsequent sell-off.

The second is approach is to look at the data over the last 20 years and draw a trend line. Our first chart shows the weekly drawdown of US Equities on a total return basis. Most of the time, the reading is at or close to zero, which means that equities are rising, but there are three significant lows in 2002, 2009 and 2020. (We also look at a fourth episode in early 2016, which was not significant for the US, but was for many other countries.)

The other line tracks the cumulative return on bonds while the equity market is below its previous high, measured from the start of each equity sell-off. For each episode we take the maximum drawdown and compare it with cumulative return on bonds on the same day. In 2002, the worst weekly drawdown was 45.8% and the return on bonds was 28.7%, giving an offset ratio of 62%. We calculate this ratio for all four episodes for the US and six other developed equity markets: Japan, Australia, Canada, Switzerland, UK, and the Eurozone.

Our second chart plots this data over time and draws a trend-line which is quite terrifying in its simplicity. The average offset ratio was 50% in 2002, 32% in 2009, 18% in 2016 and 0% in 2020. As expected, there is some dispersion around the trend, but the overall R-squared is 0.68, which is good enough, and every country on its own has a downward sloping trend. This is despite the fact that we are dealing with a denominator effect. Recent equity sell-offs have been smaller than earlier ones, which means that a smaller bond gain would have generated a higher offset ratio.

We should always be wary of simplistic extrapolation. Our argument is not that all government bonds will go down in the next equity bear market, though this is exactly what happened this year in Australia, Switzerland and the Eurozone (including Germany and France). We argue that there will be a net zero offset in most countries, with some very small bond gains in the US and possibly Canada (see Chart 3).

Even here, the best we can realistically hope for is that bonds hold their value, rather provide a significant positive return. US investors used to be able to offset about 50% of their equity losses by owning 7-10 year Treasuries. It’s a big deal if this ratio falls to 5%.

There are (or were) three main reasons for holding long-dated government bonds: income, volatility reduction and negative correlation with equities (particularly when equities go down). The first has effectively vanished across most developed markets (especially if management costs are taken into account). This exercise suggests that the third reason won’t work very well in the next bear market. Only the second reason – volatility reduction – still works, but government bonds are not the only way of achieving this – cash or derivatives can do the same.

We will explore the implications of this in future notes, but here are some ideas.

  • It makes sense for investors to separate these three objectives, to look for income and negative correlation in different asset classes. Gold can provide some negative correlation, but has no income and can be hugely volatile; real estate will provide income but has a horrible positive correlation with falling equities; derivatives can hedge volatility, but only at a cost.
  • The only way investors can achieve all three objectives in government bonds is to go much further out on the yield curve. If the 7-10 tenor no longer fulfils their objectives, they will have to own 20, 30 and even 50-year maturities.
  • Investors will also have to vacate the 2-7 year space. This means there will be large quantities of medium-dated government debt with fewer natural holders, which could make them more volatile and more susceptible to international rather than domestic factors – i.e. the foreign exchange markets.

Conclusion: The key message is that for most developed markets, in the next equity sell-off, the part of the yield curve traditionally owned by balanced-portfolio investors cannot do what the text-books say it does – mitigate equity losses.

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