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At times, the financial markets offer unique opportunities. Today is such an occasion. Despite Treasury yields plummeting in recent months, yields on the bank debt of certain American systemically important financial institutions have gone up quite a bit. And therein lies the opportunity.

If you are willing to purchase subordinated bank debt today, with the understanding that you will give up your income from those notes for a period of time, in order to ensure the safety of your principal during the crisis, then the following trades might be for you. Why would someone want to purchase a bond, only to use the interest payments to hedge the principal invested in that bond? Because that’s how you make sure that when the crisis is over, you come out on the other side with the highest yielding bonds. And, it’s also how you make sure that if there is no light at the end of the tunnel, you don’t lose most of your investment.

In “Protect Your Income Portfolio With Cross-Asset Hedging,” I outline the very strategy I’ve been alluding to thus far. And today, I have found three examples that can be executed right now.

Bank of America’s (NYSE:BAC) subordinated note (CUSIP: 060505DL5) maturing 9/15/2037 has a coupon of 6.50% and is asking 84.898 cents on the dollar (7.876% yield-to-maturity before commissions). It is non-callable and pays interest semi-annually. Moody’s currently rates the note Baa2; S&P rates it BBB+.

If you purchase $10,000 face value of this note and simultaneously purchase 80 of BAC’s January 21, 2012 $1 puts at the current asking price of $0.01, you will have done the following:

The purchase of the notes will cost $8,489.80 before commissions. At the same time, you will have spent $80 to buy yourself the right to sell $8,000 worth of BAC’s common stock at $1 per share. I have built in what I view as the conservative assumption that should Bank of America seriously look like it is going to go bankrupt, be nationalized, or suffer the consequences of any other scheme under which it will default, that the junior debt will still be trading at a price of at least 5.77 cents on the dollar before the stock is ultimately halted for good.

Whether 5.77 cents is paid out in the end is irrelevant, as you would close the puts and the bonds before the stock is even halted. In addition, chances are quite good that the fixed income market will offer you more than 5.77 cents on the dollar. This, along with the puts being so bid up from the spike in implied volatility while the stock is tanking, makes it as close to a certainty as one can get in investing that you will not only get out with your principal in hand (from the loss on the bonds and gain on the puts), but actually exit with a profit. When closing this trade during the doomsday scenario, there is no description of the exact time at which an investor should close the position. Instead, bond and put prices must be monitored for the right moment(s).

If a death spiral in the company never happens, you have paid out $80 plus commissions, while at the same time collecting $87.26 from accrued interest on the notes. The $80 loss you take on the puts will also reduce your Federal tax liability, thereby allowing one to build in at least some commissions on the puts into the hedge. When January option expiration rolls around, if you haven’t seen a resolution to the crisis that suits you, do the trade again. Under such a scenario, the chances are good that your money, earning essentially zero, will be better off than it would have been in many other investments. When the crisis is ultimately resolved, if it is resolved in a positive manner, you will be left with a long-term fixed income position yielding 7.876%. If the crisis results in a bank default, you will have lost nothing more than a few bucks in commissions, if anything at all.

Goldman Sachs’ (NYSE:GS) subordinated note (CUSIP: 38141GFD1) maturing 10/1/2037 has a coupon of 6.75% and is asking 89.36 cents on the dollar (7.704% yield-to-maturity before commissions). It pays interest semi-annually and has a make whole call, as well as additional conditional calls. Moody’s currently rates the note A2; S&P rates it BBB+.

If you purchase $10,000 face value of this note and simultaneously purchase two of Goldman’s January 21, 2012 $45 puts at the current asking price of $0.34, you will spend $68 before commissions to purchase the right to sell $9,000 worth of Goldman’s common stock at $45 per share. Since you only spent $8,936.00 before commissions on the subordinated debt, you will not have to build in any type of recovery rate on the notes. In fact, if the market does price in any type of recovery on these notes, as the stock heads towards zero, you will likely make money off of this hedge.

If the company is never at serious risk of default, the puts will expire worthless and you will lose $68 on the puts, less the gain from reducing your Federal tax liability by $68. At the same time, you will have gained $90.62 in interest from the notes over that time period, resulting in a 1.97% annualized yield (ex-commissions) during the hedging period.

Citigroup’s (NYSE:C) subordinated note (CUSIP: 172967DR9) maturing 8/25/2036 has a coupon of 6.125% and is asking 88.364 cents on the dollar (7.132% yield-to-maturity before commissions). It pays interest semi-annually. Please contact your broker for details on this note’s call features. Moody’s currently rates the note Baa1; S&P rates it BBB+.

If you purchase $10,000 face value of this note and simultaneously purchase 30 of Citigroup’s March 17, 2012 $3 puts at the current asking price of $0.02, you will spend $60 before commissions to purchase the right to sell $9,000 worth of Citigroup’s common stock at $3 per share. Since you only spent $8,836.40 before commissions on the subordinated debt, you will not have to build in any type of recovery rate on the notes. In fact, if the market does price in any type of recovery on these notes, as the stock heads towards zero, you will likely make money off this hedge.

If the company is never at serious risk of default, the puts will expire worthless and you will lose $60 on the puts, less the gain from reducing your Federal tax liability by $60. This time around, however, you will actually make some money even if the hedge ends up worthless, as the interest accrued to March 17, 2012 will be $172.84, resulting in a 4.53% annualized yield (ex-commissions) during the hedging period. This makes the Citigroup hedge the most lucrative of the three.

Sometimes it is necessary to give up something today to make your portfolio better tomorrow. By purchasing some of the high-yielding bank debt and buying puts on the common stock of those banks, you will be giving up a little bit of income over the coming months in order to give yourself the opportunity to hold notes in a too-big-to-fail bank at yields that aren’t likely to be around once the crisis ends.

Please be aware that prices in the over-the-counter U.S. bond market may vary depending on the broker you use. The current prices may also differ greatly from those listed at the time this article was written. Also, please do your own due diligence on the financial profiles of the companies mentioned in this article. Only you can determine if taking the counterparty risk of purchasing individual bonds is suitable for you.

Disclosure: I am long CUSIP 38141GFD1 (GS)

Source: 3 Bank Bonds With Hedges To Buy Now