The correlation between long-term corporate bonds and Treasury bond yields drops as bond quality drops. Their low correlation with Treasuries has led some to conclude that low quality bonds have too great a residual basis risk to be hedgeable. But the correlation coefficient between the bonds and equity of a firm increases as bond quality drops. This suggests a composite hedging strategy that consists of positions in government bonds or bond futures and positions in stock.

For bonds of the highest quality, the composite hedge is the same as a conventional interest rate hedge—it calls for a full position in Treasuries. As bond quality decreases, however, the composite hedge calls for a larger investment in the equity of the underlying firm. The exact allocations will depend on the firm’s debt-to-equity ratio, the volatility of its value and the length of time to the bond’s maturity.

For lower-quality issues, the composite hedge significantly outperforms a conventional interest rate hedge. Furthermore, a composite hedge preserves any mispricing in the underlying bonds. It thus offers a valuable tool for credit conversion: If the high-yield bond sector is undervalued, the investor can retain differentially higher returns by investing in this sector while relying on the hedge to reduce the investment’s risk to acceptable levels.