BofA Likes Long-Dated Volatility to Hedge Rising Systemic Risks

(Bloomberg) -- Investors need cheap hedges as the power of central banks to prop up markets weakens, and there’s still relative value in longer-dated volatility, according to Bank of America Corp.

A “high-strike central bank put” has defined markets over the past decade and depressed swings, but the drop in U.S. stocks after the Federal Reserve’s 50 basis point rate cut and Monday’s 7.6% S&P 500 Index plunge show that confidence in the power of central banks is waning, according to BofA strategists led by Benjamin Bowler. Investors should hedge, they said.

“Central banks will no doubt take further action (and markets will bounce at least temporarily in anticipation),” the strategists wrote. “However, their limited firepower compared to 2008, coupled with their inability to solve a global pandemic (absent coordinated fiscal and public health leadership), is driving tail risks higher.”

In BofA’s view, systemic risks abound in the current environment. In addition to the apparent loss of confidence in central banks, there’s the impact of the coronavirus on global growth, escalating financial contagion and increased likelihood of corporate defaults due to lower oil prices, they noted.

What to use to place those protective trades? The VIX is near levels not seen since the global financial crisis, making it a less-desirable hedge than longer-dated volatility that hasn’t yet reached such heights, the strategists said. They recommend S&P 500 and Russell 2000 Index December 2020/December 2021 forward-starting variance, which looks at volatility between two dates in the future and is often captured via a swap.

“Such tenors of vol have started to wake up to rising risks in recent days but remain well below fourth-quarter 2011 or second-quarter 2010 stress peaks,” the strategists wrote. “This lagged response function of longer-term vol is typical in fragility events, until risk is deemed to be systemic, not transitory.”

And if BofA’s feared risks don’t materialize to sink markets further, such longer-dated trades will also allow for time to exit should equities rally, the report said.

But investors shouldn’t count on that, the strategists wrote, emphasizing that protecting against potential further downside is a must for anyone in the markets.

“With the virus crisis likely still in its early stages, and as investors wake up to the fact the old playbook isn’t working, hedging against further downside is not something investors should ignore,” the strategists said.

To contact the reporter on this story: Joanna Ossinger in Singapore at jossinger@bloomberg.net

To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Cecile Vannucci, Yakob Peterseil

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