The Market Goes to the Dogs, Which Chase Their Tail Risk

I’ve read a number of articles on hedging tail risk of late.  Most of them were pretty good; I just want to add in my thoughts.

For those who haven’t read the articles, tail risk is when even safe investments get hit hard.  Those market outcomes are rare but severe, so some people look for insurance to clip their risks when everything is getting whacked.

Possibly a reasonable goal, and the best time to aim for it is when things are pretty good, because it is best to buy insurance when it is cheap to do so.

But what form should the insurance take?  I can think of three broad categories:

  • Assets that come into existence during the disaster.
  • Ready liquid assets — short-term and high quality.
  • Liabilities that disappear with the disaster.

The first category is the one most people think about.  What can I buy that will do well when the disaster comes?  There are two branches to that question:

  • Do I want my downside clipped on this trade (for a price)?
  • Do I want to make the bet without paying much, and I could win or lose?

In the first category are puts and buying protection via CDS, which will protect for a time, but cost money to put on the trade.  Worse, you could be right on the event, but wrong on the timing, and they end up expiring worthless.

Note: be wary of products Wall Street would like to sell you here.  Most often, they sell something mispriced to you, though it looks attractive.

But even if you are right, your counterparty/exchange  has to remain solvent in order for the trade to work.  Few factor in the cost of insolvency there.  Think of those who though they were clever laying off risk to AIG, a trade which only worked due to government intervention.

In the second category, there are assets like precious metals and long Treasury zero coupon bonds, each of which will do well in a specific crisis, but not just any crisis.  But there is also the shorting of equities and high-yield bonds, which could potentially deliver big gains, or big losses if the rally continues.

I would offer this test to anyone offering a hedge against tail risk: is it any better than puts or buying protection through CDS, or shorting equities or high yield bonds?  I would suspect in most cases the answer is no.

Then there is my preferred solution: hold cash.  Cash is unique; it can be used for anything; it can be used for almost every contingency.  Cash may offer little to nothing; it may even yield negatively, but that is the cost of security and flexibility.

Then there is the third option: offering catastrophe [cat] bonds.  Why should the guys following hurricane, quake, typhoons, and European windstorms have all of the fun?  There are more and bigger disasters than those in the financial markets.

In simple terms, here’s how a cat bond works: after a disaster that meets the terms of the cat bonds occurs, the principal of the bond diminishes by the size of the covered loss, if it is in excess of certain thresholds.  The advantage of an arrangement like this is that an insurer or reinsurer can get reinsurance against a disaster, by issuing a high-yielding cat bond.

The high-yield investors are happy to buy it because typically cat bonds are highly rated, and offer a good return that is uncorrelated with the returns on other high yield bonds.  Physical disasters seem to happen independently from financial market disasters.

The bond issuer gets reinsurance capacity, which is sometimes scarce, at a price that reinsurers would not match.  Cat bonds can never replace reinsurers, though, because the reinsurers offer more tailored coverages, while cat bonds tend to be more broad-brush.  They are usually cross-hedges for the issuer, covering something that is likely to be highly correlated with their loss exposure in a disaster.

What Might be a New Idea

What if we applied the concept of a cat bond to hedging risky security portfolios?  Think of it as an odd sort of margin account.  A hedge fund borrows money via a special purpose vehicle [SPV], which holds high quality collateral.  The hedge fund pays the SPV for insurance coverage; the SPV pays interest to the cat bond investors.  If a loss event happens, say a large decline in the S&P 500 index below a stated level, the principal of the cat bond is written down, and the SPV pays the amount of the writedown to the hedge fund.

Compared to a cat bond based on a physical event, there is one advantage and one disadvantage.  The disadvantage is that the loss trigger on a financial cat bond is highly correlated with bad high yield bond market performance, eliminating a lot of the diversification advantage.  This would mean that a financial cat bond would have to pay a higher premium than a physical cat bond.

There is an advantage, though: it can be hard to set up a large hedge without disrupting the market, and it is difficult to gain protection over long periods of time.  Most hedging instruments are short dated, and limited in the amount of capacity available for laying off risk.

Would this be attractive to a large hedge fund?  I’m not sure.  This sort of protection has the same sort of drip, drip, drip of cash out that most managers hate to see, whether for writing puts or buying protection via CDS.  It would come down to a question of cost versus a locked-in solution that could last for ten years, with little to no counterparty risk.

Conclusion

But personally, my best solution is lower your leverage and hold some cash.  Nothing beats the flexibility and simplicity of cash in a disaster.  Cash is also an index of humility; we are willing to leave something to the side in case we are wrong.  Being wrong is a normal state of affairs in investing, so take time to prepare for the next time you will be wrong.