Tail risk hedging is a strategy designed to protect portfolios against extreme market moves that occur infrequently but have a significant impact when they do. These “tail events” lie at the far ends of a return distribution and often coincide with financial crises, sharp market crashes, or systemic shocks. A well-structured tail risk hedge, typically involving options or volatility instruments, can provide substantial value during periods of heightened uncertainty.
Reference [1] proposed a tail risk hedging scheme by shorting corporate bonds. Specifically, it constructed three signals—Momentum, Liquidity, and Credit—that can be used in combination to signal entries and exits into short high-yield ETF positions to hedge a bond portfolio. The authors pointed out,
The research above constructed signals on the Investment Grade bond market to inform a dynamic hedge that deploys liquid bond ETFs as hedges to effectively and quickly protect high carry bond funds. It succeeded in lowering absolute and relative risk, increasing annualised returns, and improving Sortino for PIMIX and avoiding drawdowns for DODIX, in a realistic framework that incorporates trading costs, funding costs, and volume sized hedge positions.
Credit Risk, Liquidity, and Momentum signals derived from options, duration times spread, and cumulative duration-neutral returns respectively, each seemed to capture some orthogonal information about the IG bond market. Hedge performance considering individual signals, followed by their combination, proves this point – with an optimal improvement in Sortino of ≥ 0.7 using the joint signals. When searching the hedge model’s parameter space, results remain strong and consistent over a wide array of tested parameters.
Hedging is cost effective as the research has focused on establishing short positions in IG (LQD) and HY (HYG) bond ETFs rather than shorting individual IG corporate bonds. IG bond ETFs are liquid and have low bid-ask spreads, and establishing shorts in the IG bond ETF space via LQD & HYG provides great downside convexity which benefits the efficacy of the hedge. While IG and HY CDXs have far larger traded volumes than LQD & HYG, they do not have the same downside convexity and prove to be not as effective as ETFs
In short, it’s possible to develop an effective tail risk hedging strategy using corporate bond ETFs.
An interesting insight from this paper is that it points out how using corporate ETFs benefits from downside convexity while using credit default swaps such as IG CDXs does not.
Let us know what you think in the comments below or in the discussion forum.
References
[1] Travis Cable, Amir Mani, Wei Qi, Georgios Sotiropoulos and Yiyuan Xiong, On the Efficacy of Shorting Corporate Bonds as a Tail Risk Hedging Solution, arXiv:2504.06289
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