Interest rates are inevitably headed higher as the Federal Reserve ends its bond buying program, and recent history has shown that, when this happens, the move can be swift and ugly.
The Chicago Board Options Exchange (CBOE) has launched a product designed to allow fixed-income investors to hedge against interest-rate volatility, similar to its equity volatility index that is now widely used by investors seeking to hedge or trade equity-market volatility. The CBOE/CBOT 10-year Treasury Note Volatility Index (VXTYN) began trading in mid-November. It allows fixed-income investors, particularly investors in rate-sensitive bonds such as residential mortgage-backed securities (RMBS), to hedge for the first time pure interest-rate volatility risk based on U.S. government debt with a single product.
In the spring of 2013, when the Federal Reserve first signaled plans to begin tapering its quantitative easing (QE) program, the interest rate on the 10-year Treasury rose rapidly from 1.7% in May to more than 2.6% two months later, reaching a high of 3% in October. Treasury rates have since trended down, holding below 2.5%, but an unexpected development making the Fed to raise rates sooner than anticipated could send them soaring again, resulting in a loss of principal for products paying a fixed rate of interest.
“One of the challenges in the fixed-income space now is selling product, because a lot of people realize rates may go up in near future, and they’re concerned about standing in front of the train,” said John Angelos, director of institutional marketing U.S. and head of Asia Pacific at the CBOE. “So incorporating a product like this as an overlaying strategy, as a tail risk type of measure, could help offset some of the concerns about adverse price movements stemming from the back up in rates.”
Angelos said that the CBOE had conversations with several structured-products desks before the product launched about how it could be used. One idea is an exchange-traded fund or note that’s structured to provide exposure to the VXTYN index. More complex over-the-counter products, he said, could be designed, for example, to provide a “tail risk” hedge for a broad basket of fixed income or potentially more homogenous portfolios of RMBS or other structured bonds.
“By comparing the cash-index value of the VXTYN, which has been back-tested to 2003, a structured desk can see how it correlates with the security’s underlying asset. The VXTYN could be incorporated in those baskets with the highest correlations, to smooth out returns,” Angelos said.
Craig Stapleton, portfolio manager, quantitative strategies, at Advantus Capital Management, said that bundling the CBOE’s Volatility Index (VIX), which measures anticipated volatility in the S&P 500 over the next 30 days, with the underlying index has significantly increased returns and reduced volatility in its managed volatility fund. Performing the same exercise with the Barclays Capital U.S. MBS Index and VXTYN using data going back to 2003, however, did not appear to either boost returns or damp volatility. However, interest rates have generally been declining since 2003.
“If people believe there’s going to be scare about inflation, or a currency crisis of some sort, or a new Fed policy regime, you could see dramatic increases in volatility alongside declining fixed-income-market prices because rates are rising,” Stapleton said. “In that case, these types of products should work.”
The VXTYN is also designed to hedge volatility stemming from falling interest rates. However, if rates move sharply in one direction and then remain at that level for an extended period, the price of the VXTYN declines.
Yoshiki Obayashi, managing director of Applied Academics, which helped develop the VXTYN index, said that its correlation with the iShares Core U.S. Aggregate Bond ETF strengthens significantly alongside concerns about interest-rate risk. He said that this correlation bumped up in 2011, coinciding with worries about the impact of a U.S. debt rating downgrade, and then leaped last year amid concerns about QE tapering. However, there was little correlation in 2008, when Lehman Brothers collapsed, because that wasn’t an interest rate-driven story.
“The takeaway is the relationship between interest-rate volatility and bond performance really changes over time, and the VXTYN appears to become tightly linked to bond-portfolio performance when interest-rate risk is at the forefront of investors’ concerns,” Obayashi said.