Asset Allocation & Risk Management
Asset Allocation & Risk Management
Protecting Portfolios Against Rising Rates with Interest Rate Swaptions
IntroductionInvestors are increasingly concerned about rising interest rates, and the reality that higher rates can have adverse financial consequences for portfolios and businesses. Since the magnitude and timing of rate moves is uncertain, the question of what to do about it is both critically important and very hard to answer.
One solution is to reduce or eliminate exposure by shorting rates. This comes with the high cost of losing potential income and the diversification benefits of fixed income exposure. The ideal solution is a conditional, options-based hedge, that only reduces exposure when rates move against your position, but these can be expensive and hard to manage, and subject to path dependency if not carefully selected and constructed.
In this blog we present an alternative solution -- an optimized interest rate hedge that utilizes long-dated over the counter (OTC) swaption contracts. With the proper selection of swaption parameters, one can create a conditional hedging profile that is highly convex and robust across a broad range of rate paths, with a low-cost of ownership.
Trimming vs InsuranceOne interest rate hedging approach is to reduce or remove the exposure altogether. For investors, this can range from shortening the duration of a fixed income portfolio, taking it to cash, to the extreme of shorting fixed income securities through derivatives markets. Businesses and institutions reliant on low-cost financing typically lock up current and future financing through the use of commitments and derivatives. These approaches solve one problem, reducing losses associated with a rate rise but introduce additional problems. For investors, the income and gains generated by exposure to rates if rates stay the same or decrease is lost. For businesses or institutions, the losses associated with locking in financing for projects that may not be realized or may be realized in a lower rate environment can also be very costly.
Even large and sophisticated market participants such as Harvard struggle with this decision. Harvard’s experience during and shortly after the financial crisis is instructive as an investor, through its endowment, and as an institution that is a major participant in debt markets, as part of its university operations.
In the early 2000’s Harvard University decided to undertake a major expansion into the Boston neighborhood of Brighton, just across the river from its main campus in Cambridge. Their plan -- develop several large parcels of land they had acquired in Brighton to create a multi-billion-dollar world-class science and biotechnology campus. In addition to securing the property, Harvard also committed to fixed rate borrowing to finance the project, at a rate that seemed attractive at the time. Advance the calendar a couple of years and we find ourselves in the midst of a financial crisis which dramatically cut the value and liquidity of many of Harvard’s endowment assets, reduced the ability of its donor community to provide meaningful gifts, and otherwise stressed the university’s operating finances as grants dried up and demand for student financial aid increased.
On the endowment side, Harvard had reduced exposure to fixed income assets in favor of riskier and less liquid positions. The fixed income positions they abandoned prior to the financial crisis would have provided both a powerful diversification benefit (bonds rallied during the crisis in response to central bank action) as well as an important source of liquidity. Because Harvard’s endowment asset allocation was short on duration and illiquid, it found itself having to liquidate many of its positions at distressed prices. After they decided to indefinitely postpone the Brighton development project, the commitments they made to borrow fixed amounts at a fixed rate, eventually ended up costing Harvard about $1.25 billion to unwind.
Given this fact set, a conditional hedge that protects against rates increasing when one needs it but is less reactive to a rate decrease would be most desirable. Essentially, what we have just described is an option, a position that increases its sensitivity to the underlying risk factor as the risk driver increases and decreases its sensitivity as the risk driver decreases. As discussed in our other blogs, this type of favorable variable sensitivity is known as positive convexity. Had Harvard purchased an option on rates that paid them if rates went up instead of committing to borrow at what turned out to be higher than market rates, all they would have lost is some of the option premium they paid to purchase the option. This could have easily turned out to be a 10th of the cost incurred to unwind their financing and swap positions.
Having identified options as a potentially powerful tool, the question then becomes which options or configuration of options offers the most desirable profile. In making this determination we want to consider how the basic features of an option (market, underlying, term to expiry, strike) interact and relate to the risk management problem. In the sections that follow we take each of these features in turn to parse out an optimal option hedge for rising rates.
Why OTC Options?When we examine the options markets available to those wanting to hedge US dollar interest rate risk we see both well-developed listed and OTC markets. However, within listed options we see liquidity that is available to a limited palette of underliers; Eurodollar futures and US Treasury futures with liquidity that extends for a fairly limited set of terms to expiry inside of 1 year.
If what we are concerned about are large rate changes that may take years to develop, short term-to-expiry options are not the appropriate tool. For instance, let’s consider a scenario for the 10-year US treasury where it ends up yielding more than 4% (yielding 1.62% as of April 30, 2021) after 3 years pass. Someone using short term options to hedge this outcome would want to roll through a series of 12 6-month options held for 3 months each to hedge this risk. It’s not hard to see that the path taken in getting from 1.5% to 4% or more on the treasury yield would have a material impact on the cost and ultimate effectiveness of the hedge. For this scenario, a much more effective and predictable hedge would be one that involves a single option, with three or more years to expiry and a strike of around 4%.
This type of option, while not available in listed markets, is readily available in liquid, deep and frequently traded OTC markets. These markets are typically inhabited by banks, broker dealers, insurers, corporations and other institutional participants with very specific needs that help create the full palette of terms available. In terms of size, these markets are in aggregate larger than the listed markets when measures of exposure such as aggregate DV01 (sensitivity to changes in rates) and Vega (sensitivity to changes in implied volatility) are used as yard sticks. By accessing the full palette of terms to expiry, strikes and underlying rates available in the OTC market, one can expressly build a predictable, low cost of ownership hedge to a rapid rise in interest rates. In the section that follows we walk the reader through precise underlying rate, strike, and expiry that we believe will build the most optimal interest rate hedge.