Equity volatility, as replicated by widely traded ETFs and ETNs linked to the S&P 500® VIX® Futures Index Series, is frequently used to hedge equity portfolios. But is it appropriate for bond portfolios?
The bond market is broad and diverse, ranging from low-risk government bonds to relatively high-risk high-yield corporate bonds and emerging market bonds. As a result, equity volatility relates to each segment of the bond market in the following different ways:
- Treasury and municipal bonds are positively correlated with equity volatility because they often serve as safe-haven choices when equity risk is at heightened levels. Therefore, adding S&P 500 VIX Futures Index Series exposure to a portfolio of treasury and municipal bonds does not provide diversification benefits.
- Investment-grade corporate bonds have a weakly positive correlation with equity volatility futures, while high-yield corporate bonds have a weakly negative correlation. During extreme downturns, equity volatility futures can offer corporate bond portfolios some tail risk hedging benefits, but there are occasions when these benefits may not be realized. Risk-return benefits can also be obtained by adding a dynamic allocation of the S&P 500 VIX Futures Index Series to a corporate bond portfolio.
- The most beneficial application of the S&P 500 VIX Futures Index Series is in emerging market bond portfolios. Adding the S&P 500 VIX Futures Index Series generally provides a clear tail risk hedging benefit. Over the period of study, equity volatility futures provided downside protection on all but four of the worst 25 days for emerging market bonds. An ongoing dynamic allocation to the S&P 500 VIX Futures Index Series has also produced better risk-adjusted returns, with statistically significant outperformance.
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