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In my last portfolio repositioning in July 2008, I first made the decision to aggressively move up in capital structure, both in terms of asset allocation and how I allocate time analyzing securities. This is a decision I have regularly revisited, but with how the macro environment has deteriorated since, my preference for debt or preferred has remained. As Mohamed El-Erian points out, government involvement invariably comes at a cost to shareholders. What he leaves out, and others have focused on, is that most government capital injections effectively subsidize an institution’s debtholders. Better to be there, in my opinion, during times of trouble.

Last week, I made my first change since July. Since then, my only investments have been in Primus Guaranty stock (PRS) and debt (NYSE:PRD) – primarily the latter – and that has worked out well. In that time, I am up about 40%, while the S&P is down more than 35%. The entire time, however, the risks to the investment grade universe have grown. My estimate of a peak loss rate used for Primus’ credit default swap portfolio has risen from 1.07% to 1.52% as of the most recent quarter, and the sharp rise in the overall value of my holdings has reduced the future expected returns.

One contradiction I’ve had to deal with for several months is that as my tone was negative, I was still very heavily invested in Primus. Last week, I decided it was prudent to increase my cash balance and take some risk off the table, and I sold two-thirds of my PRS holdings. With the stock below my selling price, I am considering buying some or all of it back. At the same time, I am also weighing the possibility of further reducing my exposure to Primus to increase cash holdings.

Where am I looking to put money to work? My disposition toward the debt side is still intact; the returns to be had there are (in many cases) equal to or better than the returns typically expected from stocks. The problem is that much of the high-yielding debt is financial issues of low quality, and on the equity side there are plenty of energy MLPs which will see earnings follow energy prices off a cliff – likewise with REITs. Consumer staples might offer relatively safe earnings (though Doug Kass seems to disagree), but they also have rich valuations relative to profitability, which appears to leave little room for decent future returns.

While sitting on my hands the last few months has worked, I’m beginning to feel a more active stance is appropriate. With a comfortable year-to-date results cushion to work with, I have the ability (for now) to be patient and look to strategically press my lead. “Margin of safety” is still the central requirement I’m working around, and perhaps another washout on the equity side will finally give a fat pitch to swing at.

Chart, Primus stock

click to enlarge

Chart, Primus debt

Disclosure: I still own both PRS and PRD.

Source: Decreasing Risk, Increasing Patience with My Primus Holdings