Hedging Strategy

The increasing volatility had me thinking about strategies to minimize my risk. Better late than never I say! Borrowing to invest is nothing new, although I have never followed through on this strategy. Interest expense is fully deductible at your marginal tax rate for investments that produce income, dividends, or the potential to produce dividends.

I've often thought about leveraging a basket of blue chip dividend paying stocks but the risk involved has alway made me shy of this approach. I have used inverse ETFs in the past to hedge parts of my portfolio but this is not easy nor efficient. The pros use leverage as well as out of the money puts to hedge tail risk.

What I'm thinking about is using leverage to buy a Cdn bond ETF. Bonds are uncorrelated with most of the stocks in my portfolio. There is the flight to safety aspect of bonds as well as the general rise in bond prices with deflationary expectations. I think a Cdn bond ETF is as safe as it comes.

I do own a bond ETF XLB but not nearly enough to hedge my long equity position. I have some cash but also not enough to hedge my portfolio. Holding more cash is potentially opportunity cost so what to do?

I have a line of credit with 4% interest rate and XLB currently yields 4%.
In this case the tax deduction on the 4% expense more or less cancels the tax paid on income of 4%, so there isn't any positive carry. In this case cash has a better carry but just marginally. What I'm betting on is that in any market downturn, bonds will rally beacuse of the two reasons - flight to safety and recessionary interest rate environment.

The risk is in an inflationary environment or as in the case of Greece and Italy - a crisis of liquidity and insolvency. I think Canada is okay on both counts. Despite my hard money bias I have to admit that with all the QE, there has been little inflation.

So where are the holes in this argument?