Tail Risk Hedging in a Low-Rate Environment

Abstract

In a low-rate environment, government bonds may not mitigate equity risk as well as they have in the past. This structural shift has profound implications for asset allocation. Historically, the expected return of government bonds has been positive, and they have mitigated downside risk. In other words, they have offered something even better than free insurance: they have paid investors to buy insurance. In contrast, many option-based protection strategies are costly. Unlike government bonds, options almost always come with a negative expected return. But with real yields on most government bonds in negative territory, the tradeoffs may have changed. To control for downside risk in a low-rate environment, should asset allocators sell stocks to buy more government bonds, or should they keep a high(er) stock allocation and “hedge the tails”? We show that the answer depends on both your view on bonds and how tail risk hedging is implemented. Adding a delta-hedging program can significantly reduce, but not eliminate, the cost of tail risk hedging in addition to reducing path dependent equity exposure. The ultimate benefit of a tail risk hedging program to a multi-asset investor increases the more bearish you are on bonds.