Hedging Fixed Income ETFs got a little cheaper

by Wayne Ferbert on April 10th, 2012

We love to use fixed income ETFs in our portfolios at Buy and Hedge. If you read our blog, you also know that we most often use married puts with our fixed income ETFs. The price to hedge fixed income ETFs using married puts has come back closer in line with historical norms.

We typically expect to see the cost of a married put that is at-the-money or near-the-money be equal to the dividends you would expect to collect on that ETF between now and expiration of the put. This should make intuitive sense: to have no downside – or nearly none – you must forgo all of the dividend returns to the person that is taking the downside risk.

Remember that all fixed income comes with two risks: credit risk and interest rate risk. To be able to eliminate this risk completely, you can’t expect to get paid the dividend. But at least you retain the upside in the principal price of the ETF even though you gave up the dividend income. But we don’t typically invest assets with such a small return in mind.

It is good to see the options market for fixed income come back in line a little. It is making it a little easier to build the married put tactic we like to use in JNK and LQD and other fixed income ETFs. It was just last summer, however, that the price to hedge was so high that we were having trouble building these hedges and squeezing out some yield that made it worth our effort. If you remember last Summer, the increasing uncertainty in Europe was driving volatility up which was driving the cost of hedging up for all products. At one point, to hedge at-the-money, you had to pay MORE than the dividends you expected to collect.

Now that the put costs are a little more in line, we are looking for hedging opportunities a little more out of the money – but still tighter than we look for historically. Remember, we still believe that interest rate risk is real – and all fixed income prices will likely be on the decline on the next three-year horizon. But you can look for protection around 5% down and still squeeze out some net interest.

It is not a great trade – just a way to be invested in fixed income and still be hedged. In fact, if you are just looking for ‘catastrophic downside protection’ like say 10% down, then you can still capture about 60% of the dividend after the cost of the put is factored in. Not too bad – but still less than the historical levels. Not a bad way to invest some of your extra cash if you don’t have good stock ideas right now. But if it is a short-term trade, look for the nearer months - not the further months. And think about selling the slightly out-of-the-money calls on the near month also. JNK continues to be my favorite ETF for this type of investment.

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