Is Levering Bonds a Loser’s Game Today? By Michael DePalma and Arnab Nilim, AllianceBernstein
Multi-asset strategies like risk parity owe much of their popularity to their ability to navigate the global financial crisis. Lately, critics have cited levered bond returns as the driver—and as a looming headwind. We think they’re missing a key point.
As the latest argument goes, risk parity won by levering bonds while interest rates did nothing but fall. Now, rates are historically low and—many believe—about to rise. The critics think owning bonds at all is a bad idea, never mind levering them. Last year’s risk-parity disappointment—particularly during the “taper tantrum,” when US rates rose by well over 1% in just four months—added more fuel to the notion that risk parity’s best days are behind it.
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We think this line of reasoning overlooks an important element: bonds are a cost-effective hedge for equities in a balanced portfolio. Rates may or may not rise. If and when they do, the increase may be sudden or prolonged, and bonds will face headwinds for at least some time. But almost any investment faces occasional challenges. When it comes to balanced investing, bonds are about diversifying risks, as a hedge for equity exposure.
How do bonds stack up versus other forms of insurance?
Bonds vs. Other Portfolio Insurance
We made that comparison, starting with a risk-parity strategy consisting of the S&P 500 Index and 10-year US Treasury bonds. The strategy would be rebalanced to keep the contributions to total portfolio volatility of both bonds and equities the same. Testing various time periods and volatility measures, we settled on a leveraged 300% allocation to Treasuries.
For comparison, we looked at an alternative form of protection—an options strategy built from the S&P 500 Index and put options on the same index. We used at-the-money (ATM) put options with long expiration dates (10 years), because their interest-rate sensitivity resembles that of a 10-year Treasury bond. This simplifies the analysis and focuses it on the criticism of levering bond exposure.
We built the options strategy so that its sensitivity to changes in interest rates and the S&P 500 matched that of risk parity. An important element in this matching is the beta, or sensitivity, of the S&P 500 return to the return of the 10-year US Treasury. Historically, this beta has ranged from (0.1) to (0.3) over the past decade, meaning those returns generally move in opposite directions.
Reviewing the Scenario Results
Using various betas and interest-rate changes over one-year investment horizons, the estimated profit and loss results exposed the “risk parity’s best years are behind it” criticism.
In the current environment and over the past decade, the beta between US Treasury and S&P 500 returns was negative. When rates rose, the bond hedge outperformed the options strategy (Display 2). The options strategy lost value because of three factors: beta (the sensitivity of the S&P 500 to changes in US Treasury yields), falling volatility (which hurts options) and rising rates. Risk parity loses only on the first two counts, and is helped by the positive yield-curve roll and yield carry of US Treasuries over the one-year period. The strategies post similar returns when rates fall: the positive roll and carry of US Treasury bonds offset the outperformance of the options strategy from the other factors.
When the Treasury/S&P 500 beta is positive—an uncommon environment since the 1990s—the options strategy doesn’t fare well. It needs more equity exposure to stay in sync with the risk-parity portfolio, causing it to underperform in a rising-rate environment, when equities decline. These scenarios typically happen in periods of stagflation (slow growth and high inflation)—most developed countries haven’t seen this since the 1970s. However, such a scenario isn’t outside the realm of possibility.
Keeping the Balance in Balanced Strategies
So, in most scenarios, bonds provide more effective hedging than options do, and the simple passage of time benefits bonds over options in all scenarios. Over longer horizons than one year, carry and roll benefit bonds while creating added drag for the options.
This analysis seems to refute the doom-and-gloom predictions for risk-parity strategies. It also reinforces a key principle that seems to have been lost in the debate—that levering bonds can be an effective and cost-effective way to maintain balance in balanced strategies.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Michael DePalma is Chief Investment Officer of Quantitative Investment Strategies and Arnab Nilim is Portfolio Manager of Quantitative Investment Strategies, both at AllianceBernstein, L.P. (NYSE:AB).