Market volatility got you hot under the collar?
The rise in volatility and interest rates has, in our view, increased the relative appeal of equity protection strategies, which give pension schemes the option to retain equity exposure while mitigating downside risk.
2022 has been an eventful year, to say the least, with levels of inflation not seen for decades forcing central banks to embark on aggressive rate-hiking cycles. Coming alongside the conflict in Ukraine, this has led to market volatility, with valuations falling across equities, credit and government bonds.
In these turbulent times, however, we see some potential opportunities.
We believe one such opportunity could be the increasingly attractive levels that can be achieved via certain equity protection strategies. Much like car insurance protects against the loss from an accident (over the excess), equity protection aims to insure against a fall in the value of equities past a certain point.
One type of this strategy is what we call put-spread collar strategies, whereby downside protection on equities is paid for by selling off upside above a certain level. Note that such strategies do as such entail an opportunity cost as they forgo potential upside in some scenarios, and could still result in losses, as shown below.
The chart below shows at what level the upside is capped for a two-year 70%-90% put-spread collar; for protection against market losses beyond 10% up to 30%, the buyer is still able to participate in equity market gains up to 33% over a two-year period. As you can see, the level at which upside is capped is currently at its highest over the past decade, only rivalled by levels seen briefly in March 2020.
So why has upside retention become so high? There are two principal factors:
- Increased volatility
One of the key drivers of options pricing is the level of implied volatility in the market, with higher levels of volatility increasing the price of the options underlying the structure. For any option structure where you are going to be net selling volatility, like a put-spread collar structure, pricing may look increasingly attractive as implied volatility increases, as we have seen over 2022.
- Increased interest rates
The second driver has been the significant increase in global interest rates we have seen over 2022. US rates have risen 1.7% since the start of the year, while UK rates have increased 1.4%1; bond yields are at their highest levels seen in a decade. The impact of rising interest rates is to increase the value of call options while decreasing the value of put options, making buying protection relatively cheaper and increasing the upside cap.
Potential impact on pension scheme strategy
Over the past few years pension schemes have focused on de-risking their portfolios, with strong gains in funding levels in 2020 and 2021 accelerating this trend. To date, de-risking has predominantly been achieved by reducing equity and allocating in favour of credit. The relatively attractive return profile offered by these structures, however, may lead to schemes de-risking via an option overlay.
For example, although we have seen credit spreads widening over 2022, we are still around 70 basis points (bps) away from levels seen in March 2020. Should spreads widen to these levels over the coming two years this could result in a total return of -4% over the two years. Conversely, if spreads tighten by 50bps, to where they were at the start of the year, this would yield a return of around 8%.2
By contrast, current pricing on a 60%-90%-X% structure, where downside risk is limited to 10% for equity market falls of 40%, allows schemes to still enjoy equity market returns of up to 27% over a two-year period.
Given the significant upside opportunity, for many schemes retaining a portion of their equity exposure, combined with equity protection, could, in our view, be an efficient way to generate returns while controlling downside risk. Given relatively high levels, there could even be an argument for schemes to ‘re-risk’ into protected equities, which could be done using an option structure that seeks to provide both equity exposure and a level of risk mitigation.
As with all investing, the value of an investment and any income taken from it is not guaranteed and can go down as well as up and you may not get back the amount you originally invested. Assumptions, opinions and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass.
1. Based on LGIM internal data for 10y government bond yields as at 24 June 2022.
2. Based on credit portfolio with duration 10y. Return figures inclusive of carry on credit assumed at c. 3% over two years.