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The power of the ultra-long short

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Viktor Nossek (pictured), director of research at WisdomTree in Europe, has written a note on using ultra-long short strategies to hedge duration risk.

In ‘How to hedge safe haven duration risk with ultra-long short strategies’, Nossek writes that in articulating its exit-plan from the QE programme in October, the ECB delivered a clear message:  the eurozone economic recovery is self-sustaining and no longer in need of exceptionally loose stimulus. Deflationary risks are increasingly remote.
 
“As a result, a precedent may have been set for the eurozone’s safe haven assets to come under pressure in the near future, in the same way that US Treasuries were affected during the Fed’s taper talk in 2013. Most at risk are German Bunds, as aside from having benefited disproportionately from the vast quantities of fixed-income securities purchased by the ECB, their yields remain well below inflation. For instance, it was as recently as October 2016, that the yield on 10Y Bunds broke out of negative territory. Investors mandated with targeting income in Europe’s high-grade bond market have been forced to take significant duration risk to do so.

“Those investors that have allocated to long-dated high-grade debt in Europe in the search for yield look particularly vulnerable against a backdrop of inflationary pressures building from structurally-led demand forces underpinning the eurozone recovery. These emerging pressures on consumer prices look stickier and longer lasting than the short-lived supply shocks resulting from volatile euro and commodity price pass-through effects.”

Nossek writes that if now is the time to consider hedging the downside risks to eurozone long-dated fixed-income portfolios, then leveraged short ETPs tracking ultra-long German Bunds can serve as capital efficient hedging tools for investors seeking to protect their high grade, high-duration portfolios from these risks.

He writes: “Leveraged short ETPs are simple yet effective hedging instruments. Leveraged short ETPs are instruments that magnify the performance of their underlying exposure by a leverage factor, whilst limiting downside risk to the initial investment.”

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