Investing for Income
A financial advisor at a wire house shared this income idea with me earlier this summer. He mentioned that he sometimes recommended the SPDR Barclays High Yield Bond ETF (JNK) to his clients who were looking for income, but he was wary of its downside risk, recalling how the ETF fell more than 40% in 2008-2009.
High yield, high risk
Managing risk
The idea the financial advisor mentioned to manage risk was pairing JNK with optimal puts, to limit downside. Below is a step-by-step example of how to hedge JNK with optimal puts, followed by a table showing the current costs of hedging a handful of other income-oriented ETFs in a similar manner. First though, a general note about hedging, followed by one about volatility and hedging costs, and a reminder about what optimal puts mean in this context.
Being hedged means not having to rush for the exits
If you own an ETF such as JNK, and you're hedged when the next correction hits, you'll have the breathing room to consider how severe and long lasting that correction may turn out to be. If you're confident your ETF will recover soon enough, you might decide to sell your appreciated puts during the downturn, and use the proceeds to buy more of your ETF while it's price is down (and its yield is correspondingly higher). Or you might decide to exit your position while limiting your downside. Either way, you will have options (pun unintended) that unhedged investors won't have.
Volatility and Hedging Costs
A point I've made in previous articles (such as "An Update on Hedging the Dow") is that, if an investor is considering hedging, it's better to consider doing so when volatility is relatively low and hedging costs are relatively low. As I noted in that article, published here in May:
Volatility has ticked up slightly since then [April], with the VIX closing at 15.52 on Thursday, still fairly close to its 52-week low of 14.27 though (its 52-week high was 48.2). Volatility can spike quite quickly though, so if you are considering hedging, you may want to consider doing so while volatility remains relatively low.
The hedging costs below are as of Tuesday, August 16th, when the Chicago Board Options Exchange Market Volatility Index (VIX) closed at 32.85. If memory serves, when the financial advisor first suggested this idea to me earlier this summer, the VIX was below 20 and the cost of hedging JNK was about 50% less than it is now.
About Optimal Puts
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (also available as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
A Step by Step Example of Hedging JNK
Step 1: Enter a ticker symbol
In this case, we're hedging JNK, so we've entered JNK in the "Ticker Symbol" field in the screen cap below 
Step 2: Enter a number of shares
For this example, we'll assume the investor has 1,000 shares of JNK, so we've entered that number in the "Shares Owned" field in the screen cap below. Note that you could also enter an odd number here (e.g., 1,087), in which case Portfolio Armor would round that down to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with 10 of the put option contracts that would slightly over-hedge the 1000 shares of JNK they cover, so that the total value of your 1087 shares of JNK would be protected against the decline threshold you enter in Step 3.
Step 3: Enter a decline threshold
You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).
Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. So we've entered 20% in the Threshold field in the screen cap below.
Step 4: Click the red button
A moment after clicking the red button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge 1000 shares of JNK against a >20% drop between now and March 16th, 2012. The cost of this protection would be about $800, or about 2.10% of your position value.
Note that, to be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.
Hedging costs of a income-oriented ETFs
Below are the yields of several income-oriented ETFs, along with the costs of hedging them against >20% declines over the next several months, using optimal puts. The data below is as of Tuesday, August 16th.
| Name Symbol | Yield | Hedging Cost
| |
SPDR Barclays High Yield Bond | (JNK) | 8.03% | 2.10%*** |
iShares S&P National Muni Bond | (MUB) | 3.56% | 1.33%** |
iShares iBoxx High Yield Corp. | (HYG) | 7.75% | 3.07%*** |
iShares S&P U.S. Preferred Stock | (PFF) | 4.50% | 1.60%* |
iShares Dow Jones Select Div. | (DVY) | 3.51% | 3.57%*** |
*Based on optimal puts expiring in January, 2012.
**Based on optimal puts expiring in February, 2012.
***Based on optimal puts expiring in March, 2012.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
