Extreme Volatility

As of the end of November, the US stock market indices such as the Dow Jones 30 and the S&P 500 were up 3.9% and 12.1%, respectively. The Stoxx 600, which is a Europe-wide stock index, was still down for the year, at -6.4%. Meanwhile, the Vanguard aggregate US bond market index was up 5.5%.

During periods of extreme volatility, we typically see large daily moves in the stock market. These moves are huge in both directions, up and down; however, on average during these extreme volatility periods, the market drops substantially. Earlier this year, when the pandemic first affected the US economy, stock market volatility shot up from 13.7% in mid-February to 82.7% in mid-March (as measured by VIX — the CBOE Volatility Index). During this same time period, the stock market dropped 29.4% (one week later, the drop hit 33.8%).

Another phenomenon that always occurs with extreme volatility is an increase in Treasury bonds prices. From mid-February to mid-March, as the equity markets were plummeting, long maturity Treasury bonds went up by 17.1%. This pattern of Treasuries increasing when equity market volatility spikes always occurs.  Essentially, investors get nervous about holding any risk-bearing securities like equities and wish to park their investments in safe assets — and US Treasuries are among the safest assets in the world. So, investors sell their equities, and the proceeds are used to buy Treasury bonds, whose prices are bid up.

Therefore, Treasury bonds, especially long-maturity Treasuries, are a great hedge to extreme market volatility and subsequent equity market drops. The Treasury holdings mitigate the negative effects of equity market drops on the portfolio. As Treasury bond prices increase the effective interest rate the bond pays out decreases (mathematically, interest rates and bond prices must move in opposite directions). So if the market volatility becomes sufficiently high, interest rates will become close to zero. That is precisely what happened earlier this year as interest rates for all Treasury bonds with maturities of 10 years or less dropped under 1.0%. And, bonds with maturities of 2 years or less were paying interest rates of less than 0.2%. Of course, once bonds are paying close to zero, there is no reason to hold on to the bond. Liquidating the bond and simply holding the cash will also earn near zero, but without any of the risk of interest rates moving back up and bond prices plummeting. 

Selling Treasury positions is precisely what was done as interest rates at all maturities hit historic lows. The cash that comes from those sales may be put to work by investing it back into the equity markets, which at that point were extremely cheap due to their 30%-plus drop. So, essentially what is accomplished through this change is to significantly increase the upside of a portfolio due to the additional equity holdings. And if the markets come back up from their lows, a portfolio would rise even faster. In essence, this strategy would mitigate the downside of the portfolio by holding Treasuries, especially long-dated Treasuries, and then increase the upside of the portfolio by converting the Treasury positions into equities.

Mitigating downside and increasing upside is known as “portfolio convexity,” and a strategy that has mitigated downside risk and amplified upside risk is known as a convexity strategy.