Hedge Risky Bond with T-Bond futures : is there operational risk?

[rajeshtr]

Hi David,
All the while I thought it would be fine to hedge Risky bond with T-bond : (eg.., Long Corp Bond and Short T-bond)
My Concept : Market Risk (i.e Interest Rate) would be reduced. because with rate increase --> both the bonds will move and hence it is hedged.
Q1) : If there is an economic downturn : Corp bond prices may fall due to overall risk in the economy - whereas T-Bonds as a safe haven might not. : so i am confused if this a wrong hedge strategy

Also :
If we hedge our long Corp position with shorting T-bond futures : Is there any Market or Operational risk (i.e. Wrong hedge strategy). Hedging with a Bond Vs Bond Futures?

 

[Matthew Graves]

You're hedging the interest rate risk but not the credit risk of the corporate bond. In a downturn, credit spreads increase devaluing the corporate bond but leaving the government bond unaffected. You could use CDX/CDS to hedge out some of the credit risk if you so desired.

 

[rajeshtr]

Thanks Matthew .
1. Hedge Market risk : by shorting T-Bond
2. Hedge Credit Risk : by buying CDS protection.

Is there any problem with using futures ? (any basis risk?)

 

[David Harper CFA FRM]

@rajeshtr Right, you could hedge the interest rate risk of the long (risky) bond exposure (where the underlying exposure [risk] is to an interest rate increase) with a short T-bond futures position (because this hedge position will gain if rates drop); this is the strategy reviewed in Hull Chapter 6. Is there any basis risk? Yes! How much depends on how sophisticated is the hedge. The simplest is duration-based which is to match the dollar duration. You may find this post that I just wrote helpful: https://forum.bionicturtle.com/threads/l2-t5-63-fixed-income-mapping.3617/page-3#post-50151 ... It is very thematic that duration hedges (which are generally yield-based durations) presume a parallel-shift in the yield curve. Plus, as you may be bored of hearing duration is just the linear approximation. So, the duration-based hedge (this is hopefully familiar is only really good for small, parallel shifts in the spot rate curve. "Small" because duration is a linear approximation, and "parallel" because yield (which informs our duration) is only a single factor trying to capture the entire rate curve. So your basis risk includes an adverse steeping/flattening or twist in the rate curve. We can improve the hedge (ie, reduce the basis risk) by increasing the sophistication of the hedge, starting with moving from a single factor (yield-based duration) approach to a multi-factor (e.g., Tuckman's key rates). Classic "immunization" is the practice of reducing the basis risk to nearly zero. I hope that's helpful!

 

[rajeshtr]

Thanks David. Yes it clarifies in detail (Single Factor Vs multiple buckets, Convexity, basis risk) and also needs dynamic hedging as the factors change.