Use Principal Strip to hedge Equity Portfolio
US equities is trading at such a high level, investors should consider hedging their equity portfolio in case of a correction.
In most cases, hedging a portfolio involves cost. This means that if equity market goes higher and do not correct downwards, the hedging tool will lose money.
For example if S&P500 inverse ETF is used as a hedging tool, when S&P500 index rises 5%, inverse ETF will lose 5%.
Here is one hedging tool whereby if the equity market goes higher, investors may not lose money.
That is by buying Principal Strip. Principal strips are fixed-income securities sold at a significant discount to face value and offer no interest payments (zero coupon) because they mature at par. They are backed by US government.
Below shows the overlap of principal strip and S&P500 for the period 2001 to 2017. The circle part shows the period of financial crisis in 2008/2009. During that period S&P500 dropped 63% but principal strip rallied 84%.
Below also shows the chart of principal strip alone since 2004. The general trend for this instrument is uptrend. This is because at maturity date, price of the instrument will be at 100 if US government does not default. As long as investors hold onto the bond long enough, the price will eventually rise.
Hence this also means that if US equity continues to go up, investors may not lose money in this hedge.
What is risk to investors?
If investors draw loan to buy principal strip and loan interest goes above the yield to maturity of the strip, investors will suffer loss even though the strip appreciate in value. Yield to maturity varies between high 2% to low 3%.
Principal strips carry little call risk or default risk, they do carry interest-rate risk, meaning that when interest rates rise, principal strips prices fall, and vice versa.
S&P500 and principal strip are not 100% inversely correlated to each other. Hence this will not be a perfect hedge.
In most cases, hedging a portfolio involves cost. This means that if equity market goes higher and do not correct downwards, the hedging tool will lose money.
For example if S&P500 inverse ETF is used as a hedging tool, when S&P500 index rises 5%, inverse ETF will lose 5%.
Here is one hedging tool whereby if the equity market goes higher, investors may not lose money.
That is by buying Principal Strip. Principal strips are fixed-income securities sold at a significant discount to face value and offer no interest payments (zero coupon) because they mature at par. They are backed by US government.
Below shows the overlap of principal strip and S&P500 for the period 2001 to 2017. The circle part shows the period of financial crisis in 2008/2009. During that period S&P500 dropped 63% but principal strip rallied 84%.
Below also shows the chart of principal strip alone since 2004. The general trend for this instrument is uptrend. This is because at maturity date, price of the instrument will be at 100 if US government does not default. As long as investors hold onto the bond long enough, the price will eventually rise.
Hence this also means that if US equity continues to go up, investors may not lose money in this hedge.
What is risk to investors?
If investors draw loan to buy principal strip and loan interest goes above the yield to maturity of the strip, investors will suffer loss even though the strip appreciate in value. Yield to maturity varies between high 2% to low 3%.
Principal strips carry little call risk or default risk, they do carry interest-rate risk, meaning that when interest rates rise, principal strips prices fall, and vice versa.
S&P500 and principal strip are not 100% inversely correlated to each other. Hence this will not be a perfect hedge.
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