High yield corporate bonds and emerging market U.S. dollar-denominated bonds are both credit-focused fixed income sectors. Lack of liquidity at times for both sectors can make hedging bond portfolios a challenge. Traditionally, an index-based credit default swap (e.g., CDX, iTraxx) can be used to hedge credit exposure. However, during periods of market stress, the basis between cash bonds and the synthetic swaps can widen significantly, reducing the effectiveness of the index credit default swap as a hedging tool.
Since both are often considered risky assets, high yield and emerging market bonds tend to resemble equities in the way that they respond to adverse macroeconomic changes and shifts in market sentiment. This prompts us to consider alternative hedging instruments that utilize systematic overlay of liquid equity index derivatives to hedge systematic risk in high yield or emerging market bond portfolios.
In this paper, we investigate the relationship between the credit bond sectors and the CBOE Volatility Index® (VIX), a leading indicator of the implied volatility of the U.S. equity market. We also evaluate the effectiveness of using VIX futures as a hedging instrument for high yield and emerging market bond portfolios.