Investors are currently trying to decide between keeping more of their money in stocks or look to diversify more with bonds. There’s more to bonds than just treasuries though.
Investors using bonds to hedge their stock positions is a very popular strategy, and one that is well-promoted by the investment industry. The idea here is to look to mute your exposure to downturns in the stock market by having some of your money in bonds, which are less volatile.
If an investor has half of their investments in stocks and the other half in bonds, this will tend to smooth things over on both sides of the ledger. While returns will be muted by this, since bonds don’t go up as much as stocks do, losses will be reduced as well, because bonds also don’t go down as much as stocks do.
This is not a matter of just picking the right stocks and looking to avoid bear market exposure that way, because in a bear market, the great majority of stocks go down with the tide, just like they rise with the tide when it comes in, during a bull market.
Protecting our stock positions from market risk therefore requires that we be out of stocks with some of our money when things run against us, and bonds of various types is the asset of choice to do this with.
People are taught to be hedged at all times, even though this is not the ideal way to do this, but it does have the benefit of automating things. If you are going to selectively hedge, this will require you to pay at least a little attention to what is going on, and execute decisions when the time comes.
Almost Everyone Hedges Passively
Most investors would prefer to be completely passive in their investing, or at least very passive. They can’t afford to pay someone to manage them for them, as very wealthy investors do, nor would most qualify to invest in hedge funds, so the hands-off style of hedging is really the only thing left.
With this style of hedging, you need to build enough hedging into the plan to provide enough when you need it. While this may further reduce your returns, we need to remember that this is what we want here, to sacrifice returns for more safety, which means enough safety.
The rules of thumb out there are actually too modest if we really want to be hedged, and this ends up leaving a lot of investors more hurt than they probably want to be when the fat really hits the fire. This is all really like frying bacon, you want the heat turned down enough, which takes longer to cook your bacon but avoids you getting splattered. If you’re still getting splattered too much, you set the heat too high, and we generally do.
Not getting burned here therefore becomes the more primary goal, and this does involve paying a price, but those who use selective hedging can seek the best of both worlds by being a lot more exposed to stocks when they are running well, and much less so when they are not.
The upward nature of the stock market really exposes the flaw of a one and done hedge, with calculations that just involve subtracting your age to get what is purportedly the right mix. Over the last 10 years, no hedging has really been required with stocks, and we end up paying for insurance we haven’t really needed, and paying quite a bit in the end.
Some investors do actively manage this though, and they are turning up the volume on their bond hedging lately. That actually makes at least some sense, for those who do need to unload a lot of inventory to do it need to anticipate bear markets a little, even though individuals need not jump the gun so much since their transactions are comparatively so small.
Higher Yield Bonds May Be Worth a Look, But Need to Consider the Risks
We don’t want to necessarily stick with treasuries when we hedge, although a case can be made for choosing such a rock-solid hedge exclusively as far as it allowing for more hedging effects. What happens here is that you no longer need to worry about your bond positions, in times where there may be more uncertainty with higher yield bonds with risks that may be too high for this strategy at least.
Bonds differ in quality by quite a bit, starting with treasuries, which are the most secure way to keep your money bar none. If you put it in the bank, the bank may go under, but the U.S. government will not, at least in the foreseeable future.
In between these two we have a wide assortment of bonds that can be invested in, of various risk ratings and yields. While we very likely aren’t going to be taking a position in bonds anywhere close to big enough to trade these bonds, there are plenty of funds out there that offer bonds that cater to different risk profiles and investment goals.
We can also examine the past returns of these bond funds, and in particular, look to what happened to them during the Great Recession, which put a lot of pressure on corporate bonds. Bond funds took a hit in value as well during this time. It’s not a matter of looking to be ahead during these bear markets, it’s that we don’t want to be going down too much either, as this is our hedge after all.
Not all bonds are tame, and you could put together some bond holdings that would compete well with stock market returns over the long run. This will take us well into the territory of corporate bonds though, and to the far end of it in fact. This will therefore require at least good business conditions, which we currently have, but if things turn the wrong way, these are not the instruments we should be in.
It’s believed by the bond industry that we will continue to see bond yields drop and prices continue to climb in the near future at least. This is trending and looks like it should continue to do so as more and more people move into American bonds. With the news that the Fed doesn’t have rate increases on their radar at all now will serve to perpetuate this.
Many people don’t appreciate the fact that, as a hedge, you can profit from yields going down, because this means that the value of your bonds on the market is rising. People who used fixed hedging aren’t looking to trade them though, and funds don’t really do that much trading either, with many just being a bond index fund.
While very few of us have the means to trade bonds generally, we can trade treasuries pretty easily. If we’re using this as a dynamic hedge, moving more into treasuries when stocks are looking bullish and out of them when stocks turn around, the timing of this also corresponds with what the bond market does, and for the same reasons as ours as well.
If we’re looking at other bond instruments, there are some that may be suitable enough for a hedge, although it’s hard to imagine anyone using bonds with a C in their rating for hedging, since they need hedging themselves.
Some institutional investors are going crazy for bonds right now, and are buying pretty much anything, but investment banks and the like aren’t doing this for hedging purposes only. BBB corporate bonds are very popular these days, and we are selective with them, this at least might be in the conversation for one’s hedging position.
We’re also seeing more recommendations for higher-yield bonds from the industry, and although the yields may look tempting, and the possibility of achieving 6%-7% returns that the stock market gets on average while waving at the stocks as they plunge particularly tempting, these yields are not that high for no reason, and that reason is their risk.
We can mix in some spice to our bonds, even if we are solely using them as a hedge, but we need to be careful not to add too much, especially since if the pot starts to boil, we won’t be present in the kitchen to turn down the fire. We therefore need to be careful when we look to mix up our batch of bonds to put on the stove.