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Buy and Hedge Retirement Update: Explaining Our Fixed Income Hedges

Users of our Buy and Hedge Retirement strategy know that the portfolio is made up of long call options that own a notional amount of the S&P 500 index, and yield producing positions which is currently in fixed income.

The fixed income’s job is to help offset some the cost of hedging in our long equity exposure. The current construct includes a combination of short duration high yield ETFs (SJNK) and Senior Loan ETFs (SRLN). We use these instruments, aside from yield generation, due to the lower duration aspect. Duration is a measurement of the average time to maturity and illustrates how every 1% interest rate change will affect a portfolio.

By keeping durations lower, we already are managing some interest rate risk.

Hedges on High Yield

We currently employ a partial hedge on the fixed income position via a more liquid ETF (HYG).

HYG has a higher duration (interest rate risk) and our hedges are designed to provide some protection should high yield experience a drawdown. Typically, in high yield, drawdowns are a result of rising interest rates, increase in rate of defaults, or moving within normal correlations with equities.

These are not designed to offer 1-1 protection but rather a partial offset in portfolios.

We currently own a short duration fixed income asset (SJNK) and hedge on notionally 50% of the portfolio using a higher duration fixed income asset (HYG).

Indirect Hedges on Interest Rates

Recently you may have noticed an additional long put spread on another ETF (LQD), which is an investment grade fixed income asset.

This position notionally covers an additional 25% of the portfolio. It is designed to hedge against a move higher in rates. A good example of this might be the Federal Reserve needing to be more aggressive with their hiking program should inflation continue to run hot. While this hedge is on investment grade (higher rated bonds), you’ll notice the duration just under 9 in the table.

Selected Fixed Income ETF Durations as of July 21st, 2022

Above you can see selected durations, expressed in years, that explain the current expected change to the underlying ETF price should interest rates move higher or lower by 1%. The expectation is the hedging additional interest rate risk will be more efficient using LQD vs. more of the HYG due to duration exposure.

Its worth noting that year to date, short duration high yield has outperformed investment grade against the backdrop of rising rates. So, we’ll wrap up our update on the current hedges deployed in the portfolio.

As always, reach out to a member of the ZEGA team with any questions.