Adding credit volatility premia to a bond portfolio
The volatility risk premium is a structural feature of credit markets. It has been inaccessible to most investors but can now be captured via a Tabula ETF.
Our paper examines how adding this premium to a bond portfolio could improve risk-adjusted returns.
Implied volatility of high yield credit has been persistently higher than that realised in the past ten years, leading to a volatility risk premium which has tended to exceed that seen in equity.
One of the reasons for this is the ongoing imbalance between strong buyer demand and a shortage of sellers, who face high barriers to entry in trading OTC. Tabula has just launched an ETF based on the J.P. Morgan Global Credit Volatility Premium Index (JCREVOLP), to enable investors to access the volatility premium in CDS index options in passive form.
Our simulations have shown that replacing a portion of a) a high yield portfolio and b) a 60% investment grade / 40% high yield portfolio with the strategy can improve risk-adjusted returns.
We constructed model portfolios consisting of investment grade represented by the Bloomberg Barclays Euro Aggregate Bond Index (LBEATREU), and high yield by the Markit iBoxx EUR Liquid High Yield Index (IBOXXMJA). Adding the JCREVOLP to the portfolios resulted in improved sharpe ratios on a both a ten and five-year basis:
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