The yield on a corporate bond carries two types on risk, one is interest rate risk and the second is credit risk. Table 1 gives the traded levels in terms of yields of two corporate bond.
The PGCIL (Power Grid Corporation of India Limited) is rated AAA and is trading at a yield of 8.72% while the AA+ rated Hindalco bond is trading at a yield of 9.06%. The credit spread for PGCIL is lower than the credit spread for Hindalco reflecting the rating differential.
The yields on PGCIL and Hindalco bonds can rise if interest rates rise. The yields on PGCIL and Hindalco bonds can rise if credit spreads rise. The holder of PGCIL and Hindalco bonds may have a good amount of comfort on credit spreads remaining stable. However the holder of the bonds may not have comfort on interest rates remaining stable. Hence the holder will hedge out interest rate risk on the corporate bonds and be exposed only to the credit risk of the bonds.
Hedging out interest rate risk from PGCIL and Hindalco bonds
PGCIL and Hindalco bonds mature in 2022. The best method of hedging interest rate risk on the two bonds is to short sell a 2022 maturity government bond. Shorting a 2022 maturity government bond, which is trading at a yield of 8.04% will immunise the holder of the corporate bonds against interest rate movements. Hence if interest rates go up by 50bps, the movement in yields on the 2022 government bond and the corporate bonds will be the same i.e. yields will go up by 50bps on all the securities. The loss from the fall in price of PGCIL and Hindalco bonds will be set off against the gains made by the fall in price of the government bond (the bond has been short sold and in when short sold a rise in yields is positive).
The one catch here is that the gains and losses may not exactly even out as the coupon rate on the bonds differ. We have learned how to calculate the prices or corporate bonds and government bonds given a set of yields in tutorial. You can do this exercise for the price movements in the PGCIL, Hindlaco and the Government bond give a 50bps rise in interest rates.
The other method of hedging out interest rate risk is to sell ten year interest rate futures. In this case the loss due to the rise in yields of the corporate bonds will be set off by the gains from the fall in the interest rate future price.
The third method of hedging put interest rate risk is to undertake a CMT (Constant Maturity Swap) where the holder of the corporate bonds pays a ten year CMT. CMT’s are swaps where the floating rate benchmark is the ten year government bond and a fall or rise in the yield on the ten year government bonds leads to gains or losses on the CMT. In the case of a “payer” on a CMT, the payer is willing to pay ten year fixed every year in return for floating cash flows. The fixed rate payer gains when interest rates rise and he loses when interest rates fall.
We will go through interest rate futures and other derivatives later in the fixed income tutorials.
In the next tutorial we will look at hedging out credit spreads using CDS or Credit Default Swaps.