For the past 25 years or so the global investment backdrop has been largely focused on deflationary shocks, that is, falling demand as a consequence of competing macroeconomic forces.
In such conditions, cutting interest rates is fairly straightforward and at a time of falling inflation, bonds – especially as part of a typical multi-asset portfolio made up of 60 per cent equities and 40 per cent fixed income – might have provided enough diversification to shield against this economic environment.
Yet in today’s higher inflation world, interest rates are on the rise and bonds no longer offer the soft landing they once did to protect investment portfolios from bumpier market conditions.
Just two years into the current decade and already volatility looks to be almost as high as it has been since the 1940s. While nothing is guaranteed and the past will not necessarily dictate the future, an understanding that rising interest rates will present just as much of a risk to markets as falling rates can lead one to assume that today’s fragility may well be around for the foreseeable future.
Investment-grade corporate bonds might have once delivered twin benefits of a coupon-bearing element and duration exposure.
As a reminder, if duration indicates how a bond’s price will move in response to changes in interest rates, a bond’s convexity looks at the sensitivity of its duration in response to changes in the yield.
Positive volatility
But if bonds are not able to fulfil their previous role of downside protection against equity market falls and subsequent declining interest rates, where else might investors turn for their diversification?
If volatility is here to stay, strategies that take advantage of volatility as a positive, rather than a negative feature would be worth exploring, introducing a degree of ‘insurance’ through the explicit use of derivatives.
Looking at volatility as an asset class in its own right means that whether markets are moving up or down is irrelevant as there are opportunities to make money, or lose less money, in either scenario.
As far as volatility is concerned, the market moving up 1 per cent each day is treated the same as moving down 1 per cent each day, even if the former might be more comfortable for investors.
There are different ways to ‘buy’ volatility. One could simply buy the VIX – the Chicago Board Options Exchange's CBOE Volatility Index, a commonly used measure of the stock market's expectation of the coming month’s volatility based on S&P 500 index options.
However, its relatively high cost of ownership given that the VIX itself is not investable, and investors can only access the index via futures – typically 8 to 10 per cent a month – will eat into to any potential returns, so it is worth seeking out more cost-effective ways of investing in this asset class.
Strategies that introduce a package of options to sit as an overlay on top of their equity exposure can offer some reassurance when markets become challenging, dampening down the equity risk, should the market fall significantly.
