Capturing convexity in credit when markets fall

In times of market stress, convex, defensive credit strategies can offer valuable asymmetric exposure to counter volatility and protect capital. However, traditional instruments such as options tend to suffer from a major issue: persistent negative carry. So, how can investors protect capital more effectively?

The basic ingredients: relative value through quality and liquidity

Asymmetric exposure to large market movements can be used to investors’ advantage during periods of severe market stress. Unfortunately, the negative carry associated with convex instruments such as options means the benefits can be outweighed by the cost of the hedge. An alternative is to build a portfolio around relative value, identifying pairs of related credit spreads, then going long the higher quality, more liquid instruments in each pair and short the lower quality, less liquid ones. 

The secret sauce: identifying dislocations

Identifying relative-value combinations is not enough to provide the required performance on its own, however. A portfolio built purely around long/short credit pairings based on quality and liquidity attributes would typically have negative carry. Positive overall performance requires a third pillar: identifying dislocations and constructing trades around them.

Using proxies to understand and track the behaviour of our convexity solutions

Historical references, proxies and tests can help investors understand how our Credit and Bear Convexity strategies tend to behave. It should be noted that these proxies are not our actual positions – the core of our strategies lies in selecting the mix of bonds that offers the most attractive risk/reward balance. However, the proxies are useful in demonstrating the typical behaviour of the structures used.

LOIM Credit and Bear Convexity: historically strong during market selloffs

Two useful proxies for our Credit and Bear convexity strategies are:

1. Investment grade (IG) cash bond spreads versus IG credit default swap index (CDX) spreads
2. High yield (HY) cash bond spreads versus 2.5x IG CDX spreads.

Historically, these structures typically perform well in periods of stress. Figures 1 illustrates their behaviour since June 2008, showing marked outperformance during the 2008 global financial crisis and the onset of the pandemic in March 2020.

FIG 1. Behaviour of LOIM Credit and Bear Convexity proxies in the 2008 Financial Crisis and Covid-19 pandemic¹

Read also: Rethink, relearn, respond: portfolio stability in an unstable world

Historically tight spreads enhance potential convexity

Today’s environment differs from past stress periods in that despite a 7-8% market move, credit spreads remain historically tight. Looking at the behaviour of our proxies during the volatility driven by the onset of the Iran energy shock in March 2026, spreads for IG cash vs CDX IG collapsed sharply (see Figure 2A), while those for HY cash vs CDX IG barely moved (see Figure 2B).

FIG 2. Behaviour of our proxies in the Iran energy shock of March 2026¹

This behaviour can be interpreted largely as mark-to-market noise, as investors initially tend to keep their bond exposure and hedge risk through credit default swaps. Cash spreads therefore remain relatively resilient, while spreads on CDX tend to widen. If the selloff fades, the proxies tend to recover to normal levels; alternatively, if it accelerates, spreads can decompress, potentially delivering outsized returns.

Figure 3 illustrates their behaviour during the extreme stresses of 2008. The proxies start underperforming during the first phase of the S&P 500 selloff. However, they catch up and deliver strongly as the selloff intensifies. With both proxies currently trading at historically low levels, the potential upside in the event of an extreme market move is high.

FIG 3. Behaviour of our proxies in the 2008 Financial Crisis¹

Going back further, analysis of data covering the last 20 years shows that on average, our proxies started to perform well when S&P 500 drawdowns reached around -15%, before accelerating strongly when exceeded -20% (see Figure 4).

FIG 4. Averages of proxies’ behaviour during S&P 500 drawdowns in the past 20 years¹

Intensifying convexity

As shown, while these positions are not designed to pay off immediately, they offer the potential for strong performance as market dislocations worsen. What’s more, with spreads at near multi-decade tights, such exposures could respond to comparatively modest market weakness.