Hedging Corporate Bonds With Other Issuers

Today's post is about hedging corporate bonds with the bonds or CDS of issuers in the same industry, taking paper companies as an example. First up: Smurfit-Stone and International Paper. The two bonds below have slightly different maturities and slightly different coupons, but their prices follow a nicely linear relationship:



The actual relationship may in fact be slightly convex, or simply the bottom left data points, which date back to late 08/early 09, are anomalies due to panicking post-Lehman markets. So the IP bond may be a good hedge, but of course shorting a cash bond is not always easy, so buying CDS protection on IP would be easier if the relationship with the Smurfit bond is robust -- and it is:



The relationship is similar with a comparable bond of another paper company, Temple-Inland:



This makes Temple-Inland another good candidate for hedging the Smurfit bond.