I have some corporates due in 7-30 yrs and I want to hedge out the risk on a good portion using the futures as a proxy. Which should I seel and how much? Say I have $500k in 30 yr aa corpproates and $1 mill in 7-15 yr corporates. I have an IB acct. I want to avoid selling them as they are pretty illiquid.
If the corporate bonds are iliquid, chances are there won't be much derivatives for them. If there are derivatives, they will be even more iliquid. Why not invest in a bond fund instead?
I want to know which treasurues to sell to hedge out the interest rate risk, not that I can sell the bonds and buy a bond fund, but thax anyway.
Calculate the duration of the bonds you own and short fixed income securities with offsetting duration to nuetralize interest rate risk. Duration is akin to delta for options, it represents a change in the price of the bonds for a 1% change in interest rates. This is not a perfect hedge, this is a portfolio duration hedge against interest rates. If you want a true hedge against interest rate changes then simply hold until maturity and ignore fluctuations until then. If you are talking about credit risk that is a whole different ballgame.
Optioncoach, So how would I figure the duration of the treasury future for a given settlement month--say Sep ZB, or am I not understanding.
You can trade futures on Treasury bonds: http://www.infinitytrading.com/treasury_bond_futures_options.html But to be honest, it may not be worth it for relatively small acounts. Besides interest rates will likely LOWER in the foreseeable future; thus making your bonds worth more. When you hear rumours about the Fed RISING rates, then worry.
It is pretty complicated. First you need to calculate your portfolios effective duration. Then you need to determine how many treasuries you would need to short to offset that duration risk. Then you would need to find out the equivalent futures position that replicates shorting that many treasuries. If you want long-term hedge you might have to keep rolling the futures. Not worth it for your portfolio perhaps. Maybe you can look at interest rate options to hedge on a rise in rates. Not as easy to hedge bonds as it is stock portfolios but it can be done if you put in the math work. Look for Wilmott's website or books on mathematics of finance and bond portfolio hedging.
Consider short-selling the iShares "LQD" ETF against those corporates. It should correlate better than using a treasury-based instrument.
If you have access to Bloomberg, and are willing to play with Excel, this might be feasible. Use the func "DURATION" in excel to calculate the modified duration your bonds. Then use the "FYH" function in Bloomberg and enter in a cash bond. It should compute a futures hedge. I am obviously missing steps here, because really I don't know what I am talking about, but maybe someone more knowledgable can step in. Also, having to roll and adjust your futures positions for years could be cumbersome (redoing all the calculations) and expensive (depending on spread and your comissions).