Saturday, December 9, 2017

Corporate bonds and managed futures - A winning diversification combination

Treasury bonds provide good diversification benefit against equity moves with a negative correlation that has lasted for years. This benefit will persist even with an increase in correlation between these two asset classes; however, there can be further improvement in diversification if an investor holds corporate bonds that offer higher yields. 

Corporate bonds offer more cushion against an equity decline than a Treasury portfolio given their higher current yields. The credit spread provides more yield offset; nevertheless, there will come a point when having a credit sensitive product actually acts as a drag. Credit and equity premiums both are tied to the business cycle.

If an equity decline is related to or suggestive of an economic downturn, then holding credit premium can be a negative as spreads widen. The total return effect from the spread widening may swamp the yield advantage. At this point, a managed futures strategy will take over as a better protective diversification instrument. 

Managed futures may not generate crisis alpha if there is no crisis, a sustained decline in equities. Managed futures may not provide as strong a cushion diversification effect during normal times since the correlation between equities and managed futures is slightly positive and there is no managed futures yield.

So how can an investor get the best of both worlds, the cushion protection from bonds and the crisis protection from managed futures? It can be done through using the inherent advantage of margin in futures. 

Managed futures will generally have a margin to equity level of under 20%; consequently, the excess cash, non-margin funds, can be managed as a corporate bond portfolio. Similarly, managed futures can be employed as a overlay on a bond portfolio to provide both current yield and crisis alpha. The combination will be uncorrelated with equities but as a combination will generate better stand alone return than a cash-futures combination or a bond only allocation.


Changing the risk profile from credit to macro - Take away liquidity risk and switch alternative risk premiums

I am working on a longer research piece to show the numbers for why this combination works. 

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