IVOL - IVOL: A Great Way To Hedge Rate And Equity Market Risk

2023-06-19 23:39:25 ET

Summary

• The Quadratic Interest Rate Volatility and Inflation Hedge ETF is a good buy due to the inverted bond yield curve and high yield on inflation-linked bonds.
• IVOL can benefit from yield curve steepening or declining real bond yields and offers a hedge against a decline in equity market risk.
• Two main macroeconomic scenarios that could drive a recovery in IVOL are a sharp drop in short-term rates due to recession or a recovery in inflation expectations.

The deeply inverted bond yield curve and the elevated yield on inflation-linked bonds make this a great time to buy the Quadratic Interest Rate Volatility and Inflation Hedge ETF ( IVOL ) to benefit from yield curve steepening and/or declining real bond yields. The IVOL also offers a way to hedge against a decline in equity market risk.

IVOL is a fixed-income ETF that holds a portfolio of inflation-linked bonds and options that seeks to hedge against a steepening yield curve, whether from falling short-term interest rates or rising long-term interest rates. The bulk of the IVOL's assets are held in the Schwab U.S. TIPS ETF ( SCHP ) which holds inflation-linked bonds with an average maturity of 7.4 years, which benefit from rising inflation expectations. The remainder is held in OTC options which seek to benefit from yield curve steepening, particularly the spread between 2-year and 10-year interest rate swaps. The chart below shows how the IVOL has been closely correlated with both the SCHP and the 2s-10s spread since its inception in 2019.

The IVOL has had a horrid time over recent years as short-term rates have surged higher, with the ETF losing over 20% over the past two years. The collapse in the yield curve has seen the IVOL underperform the SCHP significantly due to the losses seen on its options. The high expense ratio of 1.03% has also acted as a drag.

A Reversal Is Growing More Likely By The Day

However, conditions are now highly favorable for the IVOL. Firstly, the real yield on the SCHP has risen to 1.5%, which is significantly above its long-term average and is far too high in the context of high debt levels. Secondly, the spread between 10- and 2-year bond yields is extremely negative. The combination of an inverted yield curve and high 10-year real yields means that 2-year rates are now extremely elevated relative to long-term inflation expectations. The spread between 2-year yields and 10-year inflation expectations is now a lofty 2.5%, and the IVOL is essentially a bet on this spread moving lower.

Two Bullish Macro Scenarios

I see two main macroeconomic scenarios that could drive a recovery in the IVOL, noting that we are most likely to see some combination of the two. One is that we see a sharp drop in short-term rates as we enter recession. Leading economic indicators continue to point to a recession, with the Conference Board's Leading Economic Index now down 8.0% y/y, which has never been seen outside of an official recession.

While this would likely cause losses on the IVOL's SCHP holdings as inflation expectations tend to fall during a recession, the ETF would benefit from a sharp steepening in the yield curve. The 19% rally in the IVOL amid the sharp drop in short-term rates that resulted from the regional bank failures in March highlighted the extent to which the IVOL can rally on yield curve normalisation.

Another scenario is that we see a recovery in inflation expectations, which would drive up the IVOL's SCHP holdings and also put upside pressure on long-term yields to the potential benefit of its option holdings. 10-year breakeven inflation expectations sit at just 2.2%, which is a long way below headline CPI of 4.0% and the 10-year average of 2.7%. A rise in commodity prices is one potential trigger that could cause bond market investors to expect current elevated inflation to persist.

Main Risk Comes From Continued Equity Market Gains

The main risk to the IVOL ETF comes from a continuation of the trends in place over the past year, with short-term rates continuing to rise even as inflation pressure declines further. The speed of the rate hikes combined with the collapse in money supply amid quantitative tightening has led bond investors to anticipate a protracted easing cycle, keeping the yield curve inverted. With the yield curve now at its most inverted level since 1981, and the spread of 2-year rates over money supply growth at record lows, there is a limit to how much longer the Fed can keep rates elevated before we see a credit crunch.

However, one key risk is that the recent rally in US technology stocks continues, forcing the Fed to maintain highly restrictive policy to try to prevent another stock mania as we saw in the late-1990s. 2-year bond yields rose to a peak of 6.9% in 2000 before the tech bubble burst, finally allowing rates to move back down in line with the real economy, and a repeat of this would cause significant losses for the IVOL. Options contracts also have embedded leverage in that the investor's overall exposure to the underlying strategy that the options are based on is greater than the value of the options. Nonetheless, I believe that now is a great time to get exposure to the IVOL from a tactical perspective, and a particularly good time to use it as a hedge against stock market declines.

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