High-yield bonds contain a significant component of embedded equity. Because of this equity component, one can use equity-related investments as hedging vehicles to control the total risk of high-yield bonds. A composite hedging strategy, for example, is based on the proposition that a high-yield bond is a dynamic combination of equity and riskless bonds. Yet another hedging strategy involves shorting an equivalent portfolio of long stocks and short calls to eliminate the equity risk of high-yield bonds.
The composite hedging technique performs well at the portfolio level, suggesting that any portfolio of high-yield bonds constructed to track a diversified high-yield bond index would be a suitable candidate for a composite hedging strategy. If the portfolio of high-yield bonds is not concentrated in a specific equity sector, however, it is likely to be less influenced by its equity component and can be hedged simply with interest rate futures. Hedging results for the bonds of three individual firms suggest the potential for molding risk-return tradeoffs by focusing separately on equity risk or interest rate risk.
A statistical investigation of the market’s perception of impending default indicates that market parameters signal a default up to 10 months before the event. This should give investors enough time to work out of a long position in the bonds or to short enough stocks to protect against a precipitous decline in bond and stock prices.