In a previous article, “Forget The Insurance Company, Build Your Own Annuity,” I offer some insight into how an investor can build an income portfolio using individual bonds, rather than bond mutual funds or bond ETFs. Given that we live in a period of historically low interest rates, ongoing unconventional monetary policy, massive budget deficits, general uncertainty as to the future outlook for economies, and bailouts galore, it is understandable why some investors might be hesitant to allocate a significant amount of money into fixed income, let alone an individual bond.
When investing in fixed income, two risks are generally brought to the forefront: The first and most widely touted is inflation risk, and the second is counterparty risk. Inflation risk refers to the risk that any payments you receive from your fixed income investment will not keep up with rising prices. Counterparty risk refers to the risk of the entity you lent money to being unable to service and/or pay back its debt obligations.
While inflation risk is the one most often cited by the investment community as the biggest threat to a bond investor, I believe that counterparty risk is the larger concern for the fixed income community as a whole. Fixed income investors are ultimately most interested in a return of their investment, rather than a return on their investment. If it was the other way around, much of the money in the world of fixed income would likely flow into equities, as the potential returns in the equity markets are widely believed to be higher than in fixed income. It is for this reason that I will focus on counterparty risk when offering a simple strategy for investors to hedge their individual bond holdings.
A brief, high-level review of the capital structure of a company is in order before revealing the hedging strategy for counterparty risk. In the event a company cannot fulfill its obligations, the first investors to take the hit are the common stock holders. Next up would be the preferred stock, then the subordinated debt (also referred to as junior debt), and finally the unsubordinated debt (also referred to as senior debt). There are more slices of the pie to consider, such as unsecured versus secured debt, but for the purpose of this article, the previous outline should do.
A not too distant example of this can be found in the Lehman Brothers bankruptcy, where senior creditors are still in the process of negotiating a payout. An April 2011 Wall Street Journal article was reporting possible recovery levels between 16 and 21.4 cents on the dollar for senior unsecured creditors. Of course, the common stock got completely wiped out. And therein lies the key to the hedge.
If the common stock gets wiped out first, then as a bondholder, even if you own junior debt, there is an opportunity to own the debt and short the stock, completely hedging away your risk to principal, while sometimes even maintaining an adequate yield on the investment. Let’s look at an example:
At the moment, the Goldman Sachs (GS) subordinated note (CUSIP: 38141GFD1) with a coupon of 6.75%, maturing on 10/1/2037, has an asking price of 96.611. This means the bond will pay you 6.75% annually (payable in semi-annual installments) and is currently being offered for sale at 96.611 cents on the dollar. On a $10,000 investment, you would currently put up $9,661.10, plus a commission from your broker, receive $675.00 in annual interest payments and $10,000.00 at maturity, assuming Goldman Sachs does not default on its obligations before 10/1/2037.
If you own this bond, are concerned that Goldman Sachs might default on its obligations, and want to hedge your exposure, you could purchase a put option on the common stock for Goldman Sachs. By purchasing a put option, you are purchasing the right, but not the obligation, to sell Goldman’s common stock at a certain price. If you purchase, for instance, two January 21, 2012 $50 puts for $0.68 (current asking price), you would spend $136 and give yourself the right to sell 200 shares of Goldman Sachs at $50 per share any time between your purchase date and the date they expire, January 21, 2012.
Two hundred shares at $50 per share is $10,000 worth of Goldman Sachs common stock that you’ve bought the right to sell. Since Goldman’s common stock will get wiped out before the junior debt if the company is in peril and the stock heads towards zero, you would sell those puts at a time of your choosing, or buy the stock in the open market and exercise the puts, while simultaneously selling the bonds (if you so choose), thereby generating a profit on the puts that will offset most, if not all, of your losses in the bond. Under certain circumstances, you might even make money on this hedge.
If the company is never in peril of bankruptcy, then you have given up $136 (plus a commission) of your future interest income through January 21, 2012. There are 80 days between now and January 21, 2012. At $675 in interest per year, the 6.75% 10/1/2037 Goldman Sachs subordinated bond will accrue $148 in interest.
Therefore, when subtracting the $136 hedge (excluding commission), your return on the bond will be essentially zero over the next 80 days. You will have bought a bond at a discount, with a coupon of 6.75% that can be tucked away into your fixed income portfolio. You will have also completely hedged away your risk of loss to the principal for 80 days, and at a later date you can revisit your opinion of the company and decide whether you wish to hedge the bond going forward or earn the entire 6.75% it will pay out.
In terms of hedging against inflation, you would take a very similar approach. However, instead of purchasing puts on a company stock, you would instead focus on call options (on any type of investment which you feel will hedge you against inflation, i.e. precious metals, equity indices, etc.). A call option gives the owner the right, but not the obligation, to purchase a security at a particular price. You could even buy put options on a bond ETF that corresponds to your fixed income positions. For instance, you could purchase put options on the TLT if you own long-term Treasury bonds.
Both types of hedging strategies for your long-term fixed income position could be replicated in literally thousands upon thousands of different ways. It all depends on the company you choose, your time frame, and how worried you are about a default or inflation. You need not even hedge the entire fixed income position; you could do a partial hedge. The great thing about this hedging strategy is that because there are so many different ways to construct it, it allows each investor to personalize it to his or her own portfolio needs.
Additional disclosure: I am long CUSIP number 38141GFD1.