Bond Hedged Portfolios And Options Hedged Portfolios
When managing downside risk in an equity portfolio, a bond-hedged portfolio such as the classic 60/40 mix relies on the historical negative correlation between stocks and bonds to cushion market declines. During recessions or periods of economic stress, bond prices often rise as investors seek safety, which can help stabilize returns and reduce volatility in a diversified portfolio. It’s a well-understood, cost-effective strategy that has worked for decades, particularly in deflationary or low-rate environments.
However, the limitations of bond hedging have become increasingly apparent in recent years. In inflationary or rising interest rate environments, bonds tend to lose value alongside equities (2022), eliminating the diversification benefit investors rely on. In these scenarios, an options-hedged equity portfolio becomes more compelling. By using long-only equities for growth and layering in protective puts, investors can maintain full upside exposure while limiting downside risk with defined floors. This approach allows for more precise control over risk, especially in volatile markets or when equity valuations are stretched.
An options-hedged portfolio is particularly well-suited for clients with high growth ambitions but low tolerance for large drawdowns. While protective puts do carry a cost—typically reducing annual returns by a few percentage points (2-4 percent)—they can significantly mitigate losses during severe market downturns like those in 2008, 2020, or 2022. This strategy also sidesteps the duration risk inherent in fixed income and can be tailored to reflect specific time horizons, market views, or levels of risk aversion.
Ultimately, the decision between bond and options hedging comes down to the investor’s objectives, market outlook, and appetite for complexity. Bond-hedged portfolios remain a strong default for long-term investors in stable environments. But in an era of macro uncertainty, inverted yield curves, and elevated equity risk, options hedging offers a more adaptive and targeted way to protect capital while preserving growth potential. We do not have a cookie cutter method for using bond hedged or options hedged portfolios, everything is tailored to the client’s situation and macro data. Below is an investment policy statement we crafted for a prospective client. In this scenario we used investment grade corporate bonds.
