One way to hedge portfolios against interest rate risk in the corporate bond world is to take short positions in U.S. interest rate futures contracts.
Andrew Kronschnabel, portfolio manager at Logan Circle Partners in Philadelphia, is currently doing this with ultra-long-term Treasury bond futures and five-year Treasury note futures. He manages the Renaissance U.S. Dollar Corporate Bond Fund.
“The market is very efficient with respect to interest rate risk, or the pricing of government securities in the market, but is less efficient in the pricing of corporate credit securities,” he says. He’s referring to securities that are exposed to credit risk, pre-payment risk and illiquidity risk, which is something “you don’t have with U.S. Treasury securities.”
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He explains he’s taking short positions in U.S. treasury futures “to replicate the interest-rate exposure of our index. The reason we’re short five-year [and] 30-year futures contracts right now is because we’ve purchased five-year [and] 30-year corporate bonds in the portfolio, in a weighting that is in excess to the weighting in our index.”
So, he continues, “We use U.S. Treasury futures as a tool to remove duration exposure or more closely align the portfolio with the interest rate risk posturing of the index […] As an investor, you’ll [then] be sure returns are coming from the individual issuer-level securities or sales of the portfolio.” He also shorts the futures so investors know the returns come from “sector weightings relative to the index—or what we call idiosyncratic or macro positioning — [rather than] from interest rate decisions or biases.”
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Once these potential biases are removed, managers can focus on security selection, credit selection and sector rotation, says Kronschnabel. “We’re not using short positions to get exposure to the market,” he notes, but to “bring down exposure in the bands of interest rate risk we have in the portfolio.”
An added benefit of taking short positions is you can get increased portfolio liquidity, says Kronschnabel. “The most liquid corporate securities in the market are the ones that are most recently issued. And the most recently issued securities tend to be five-year, 10-year or 30-year securities.” But, the index his fund is measured against can consist of securities that fall outside of those groups and that are much less liquid.
So, when he’s trying to boost liquidity, he says, “We’ll be more in on-the-run securities and will have to use more interest rate futures to bring exposure down to particular points on the credit curves.” On-the-run securities or contracts are those that are more recently issued and, as such, are most liquid and trading at a premium to other securities.
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