A Different Way To Get Long Gold

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 |  Includes: GDX, GLD, IAU, NEM, SLV
by: The Financial Lexicon

When it comes to gold, everyone seems to have his or her favorite way to be long. From the miners, ETFs, futures, and equity options, to physical bars, American Eagle bullion, and numismatic coins, there is certainly no shortage of ways to have exposure to the direction of gold prices.

I would like to present a different way to have exposure to gold prices using a strategy that involves being long both deep in-the-money calls on your favorite physical gold ETF (GLD and IAU are two popular examples) as well as being long the senior bonds of a large, well-established gold miner.

Let me explain the strategy by addressing each portion of it individually:

Buying deep in-the-money calls on an ETF that tracks the price of physical gold is one way to leverage up your exposure from the long side. For example, at its recent close of $154.65, 300 shares of GLD would cost $46,395 ex-commissions. However, purchasing three of GLD's January 18, 2014 $80 calls at the current price of $77 will get you long exposure of 300 shares (1 contract = 100 shares) for a cost of only $23,100 ex-commissions. By gaining long exposure with deep in-the-money calls, you maintain all the upside that owning 300 shares of GLD would provide above $157 per share ($77 cost plus $80 strike price) with a much smaller investment. If the price of GLD plunges, and your option expires worthless, you would lose no more money than your investment in GLD would lose if you owned the shares, with one exception. If the options were exercised, your cost basis would be $157 versus the current price of $154.65. That difference of $2.35 per share is the cost of owning the options until expiration and represents the extra money you would lose if the price of GLD plunged and you held the options until expiration.

But what if there were a way for the long-term gold investor to take some of the $23,295 saved by investing in the call options rather than in shares of GLD ($46,395 minus $23,100) and use the money to generate enough income to offset the difference between the options' exercised cost basis and the price of GLD (the $2.35 mentioned above)? This is where the bond portion of the strategy comes into play.

I previously mentioned that the bond side of the position would involve a large, well-established gold miner. Let's use Newmont Mining (NYSE:NEM) as our example and start by outlining the details of the following bond:

Newmont Mining's senior unsecured note (CUSIP: 651639AP1) maturing 3/15/2042 has a coupon of 4.875% and is asking 94.332 cents on the dollar (5.253% yield-to-maturity before commissions). It has a make whole call, is callable at par beginning 9/15/2041, and pays interest semi-annually. Moody's currently rates the note Baa1; S&P rates it BBB+.

By purchasing $10,000 face value of this bond for a cost of $9,433.20 (ex-commissions), an investor would collect $487.50 on an annual basis, a 5.17% current yield. The paid and accrued interest between now and January 2014's option expiration day would be approximately $808. Therefore, an investor buying the January 2014 calls and the 2042 maturing Newmont Mining bond mentioned above would be long gold through a total investment of $32,533.20, instead of the $46,395 it would cost to buy 300 shares of GLD. Furthermore, the investor would receive approximately $808 in income from the bond position between now and January 2014's option expiration day. The $2.35 per share difference between the exercised cost basis of the options and the current price of GLD comes to $705 ex-commissions (3 contracts X 100 shares X $2.35). This is less than the amount of interest paid by the bond and should leave enough room to cover the commissions on the position.

To summarize, instead of spending $46,395 to acquire 300 shares of GLD, this strategy allows an investor to own the equivalent of 300 shares using call options and have the same upside potential as a holder of GLD shares. This is by virtue of the fact that the income from the bond position eliminates the extra cost of owning the options over the shares. And, all this is done for just $32,533.20. In other words, here is a strategy that will cost less, provide the same exposure, and be less volatile should things go awry in the near future (the option's price will not decline on a 1:1 basis if the price of GLD goes much lower as a result of a falling delta). Furthermore, since the bond position is through a gold miner, the entire position is still essentially tied to the fortunes of gold.

For investors interested in this strategy but nervous about entering a position in a long-term bond, I offer the following thoughts:

First, keep in mind that corporate bonds trade at spreads to Treasuries. At times, the spread will widen. Other times, it will narrow. In recent days, the bid/ask for the Newmont Mining bond mentioned above has been falling in price, playing a bit of catch up to the stock price's massive fall. This has occurred despite the 30-year Treasury bond generally trending higher in price over the past several days. Therefore, if yields on benchmark Treasuries do rise in the coming weeks/months, but the situation for gold miners stabilizes, the spread on the Newmont Mining bond could easily narrow once again, providing a hedge to rising Treasury yields. It may not completely offset rising benchmark yields, but it could certainly help.

Second, if you are planning to be a long-term investor in gold and you find the current yield on the Newmont Mining bond acceptable, you can continually use this bond over the years for the fixed income side of the strategy instead of having to go shopping for new bonds every couple years. Also, keep in mind that the bond will mature at par (assuming no default), which means that if you are at least willing to hold to maturity, you can ignore the mark-to-market changes in the bond's price.

Third, if a longer-term bond simply doesn't fit your investment thesis, here is an alternative: Newmont Mining's 3/15/2022 maturing, 3.50% coupon note, CUSIP 651639AN6.

Last, if you simply are not interested in using fixed income to offset the extra cost of owning deep in-the-money call options instead of shares, you could either pay that premium every couple years or do the following: explore short put possibilities using far out-of-the-money puts on the Market Vectors Gold Miners ETF (NYSEARCA:GDX). The $25 and $30 January 18, 2014 are two strike prices worth looking at.

Finally, for those investors more interested in precious metals exposure through silver (NYSEARCA:SLV), it is more difficult to find silver companies with bonds available for purchase by retail investors. However, if you are comfortable with a part silver, part gold exposure position, then it's certainly worth considering implementing the strategy mentioned above using a Newmont Mining bond in conjunction with SLV.

Disclosure: I am long NEM.

Additional disclosure: I am long gold. I am long silver. I am long CUSIP 651639AP1.