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With economic data softening worldwide and the seemingly never-ending crisis in Europe flaring up once again, it makes sense that investors would want to exercise caution. With that in mind, I'd like to present a strategy that involves multiple investment vehicles and is meant for longer-term income-oriented investors. It is not possible to execute the strategy on every public company's capital structure. But, when you do find the right combination of bond prices and option premiums for a certain company, this strategy will allow you to capture the higher yields that occur when corporate bond spreads widen while hedging away the credit risk for a certain period of time.

As investors in the steel industry know, recessions can be particularly brutal on the stocks of steel companies. One company exposed to the cyclicality of the steel industry is U.S. Steel (NYSE:X). If you are interested in this company but are concerned with the possibility of a world-wide recession further crushing its already beat up stock and possibly putting its business at risk, you might consider doing the following instead: buy a senior unsecured bond and hedge away the risk by buying put options on U.S. Steel's stock. The expiration date on the put options should be far enough into the future that it covers the time period during which you fear a recession or a risk to the business is possible.

U.S. Steel's senior unsecured note (CUSIP: 912909AD0) maturing 6/1/2037 has a 6.65% coupon and is asking 83.25 cents on the dollar (8.242% yield-to-maturity before commissions). It has a make whole call and pays interest semi-annually. Moody's currently rates the note B1; S&P rates it BB. If you purchase $10,000 face value of this bond at the current asking price of 83.25 cents, it would cost $8,325 (ex-commissions).

Moody's estimates the loss given default on U.S. Steel's senior unsecured notes to be 67%, meaning the recovery would be 33 cents on the dollar ($3,300 for a $10,000 face value purchase). According to Moody's February 29, 2012 Annual Default Study, from 1982 to 2011, the average recovery rate among senior unsecured notes was 36.8%. In 2010 and 2011, they were actually higher, at 49.5% and 40.4% respectively. Just to be extra cautious, let's plan for a recovery rate of only 25%.

With a 25% recovery rate, the bond would return $2,500 of the $8,325 in the event of default. This would mean a loss of $5,825. In order to hedge away the risk of losing $5,825 on the bond, let's look at shorting the bottom of U.S. Steel's capital structure, the common stock, using put options. An investor owning put options has the right, but not the obligation, to sell stock at the strike price chosen. By going out to the January 2014 expiration, an investor would buy him- or herself approximately 19 months for global concerns to subside and for U.S. Steel and the steel industry to get themselves on more solid ground. By purchasing the U.S. Steel January 18, 2014 $3 put option at the current asking price of 31 cents, the bond investor could hedge away the entire $5,825 with the equivalent of 1,942 shares of stock. Since one option contract equals the equivalent of 100 shares of stock, the bond investor would need to purchase 20 contracts (2,000 shares worth of stock) to cover the $5,825. The purchase of the 20 contracts would cost $620 (ex-commissions).

If the bonds were ever at serious risk of default, the bottom of the capital structure, the common stock, would get destroyed. You, the bond investor holding the puts, would look to sell the puts as close to a stock price of zero as possible. If the market maker in the options market were making your life difficult (playing games with the spreads to not offer you an acceptable price), you could simply purchase the stock in the open market and exercise the options, thereby realizing a profit on the options. If you are nervous the stock wouldn't make it to the lower rungs of penny stock territory before you would want to close the hedge, you could always purchase more than 20 contracts and close the puts at a higher stock price.

Between now and January 2014's option expiration, the U.S. Steel 6.65% coupon bond will accrue approximately $1,035. After subtracting the cost of purchasing the 20 put options mentioned above ($620), the bond investor is left with $415 in accrued/paid out interest over the roughly 19 month time period. This would amount to approximately $266.68 on an annual basis. Even after hedging away the risk to the $8,325 original investment, the investor is left with an annual yield of 3.20% on the bond during the time period in which the risk of loss is hedged away. It's as if the investor is holding a nearly risk-free 3.20% 19-month bond that will either expire within those 19-months (in the event of default) or turn into an 8%+ yielding bond after the put options expire. The reasons I didn't say the investment was completely risk-free is because one can't say with absolute certainty what the recovery rate would be in the event of default, each investor would likely purchase a different amount of put options depending on his or her risk tolerance, and each investor would close those put options at different times.

At this point, a brief summary seems in order. An investor purchasing $10,000 face value of the aforementioned U.S. Steel 6.65% coupon bond at 83.25 cents on the dollar would spend $8,325 (ex-commissions). In the event of default, assuming a recovery rate of 25%, the investor would get back $2,500 of the original $8,325 investment. In order to hedge the potential $5,825 loss ($8,325 investment minus $2,500 recovery), the investor could purchase 20 January 18, 2014 $3 puts at 31 cents. This would cost $620 before commissions. The 6.65% coupon bond will accrue approximately $1,035 between now and the January 2014 option expiration. When subtracting the cost of the put option hedge ($620) from the bond's $1,035 of interest, the investor is left with $415. When annualizing the yield on the $415 of profit, the investor would be left with a 3.20% yielding bond and an investment that is hedged for the next 19 months.

To wrap up the discussion of executing this strategy, I'd like to note that timing matters. An investor would want to execute this strategy at a time before the stock gets so crushed that option premiums have spiked to a point at which the opportunity is gone. Also, an investor would want to execute the strategy after some company/industry/macro-wide stresses were built into the bond's price and yield. The main goal of this strategy would be to get a yield that is higher than that which you would be able to get after the economic difficulties subside yet be able to hedge away the risk until the difficulties pass, just in case the company doesn't make it. If the puts expire worthless and economic stresses remain, you can consider buying puts again.

Since we are living in a world in which cash is yielding almost zero, the opportunity cost lost on your principal from using the bond's interest to buy put options is practically nothing. If you buy a long-term bond with money currently sitting in cash, the chances are pretty good one of the following three things will happen before maturity: times will eventually improve and you won't have to hedge the risk every couple years until maturity; times will get so tough that the business defaults and the position goes away with no loss and no gain; or, the company muddles through and never seems like it's going to make it but also never defaults. Under that third scenario, you would have to decide whether you simply want to exit the investment, or, if you bought the bond at a large discount (like the U.S. Steel bond), you could hold onto it long enough that the price starts to work its way towards par (at which it matures). When it eventually trades at a price higher than you bought it, you could then sell it for a profit. Of course, you could also hold the bond to maturity and collect the coupon.

In anticipation of investors with an interest in U.S. Steel also being interested in other companies with exposure to steel, I took a look at AK Steel (NYSE:AKS), Nucor (NYSE:NUE), and ArcelorMittal (NYSE:MT). As I mentioned in the opening paragraph, it is not possible to execute this strategy on every company's capital structure. While AK Steel does have high-yielding bonds, CUSIPs 001546AM2 and 001546AL4 being two examples, the option chain isn't cooperating. The option premiums are simply too high relative to the coupons on the bonds to make the hedge worthwhile. Nucor has the opposite problem. Its option chain could work if its bonds were trading at attractive prices. You can get the strategy to work with Nucor's 12/1/2037 maturing, 6.40% coupon, senior unsecured note, CUSIP 670346AH8. However, the bond is currently offered at 136.463 cents on the dollar. At that price, given the make whole call attached to the bond, I wouldn't be comfortable taking the chance.

ArcelorMittal, on the other hand, has a few bonds that fit the bill for this strategy, and its option chain is also cooperating at this time. The following three ArcelorMittal bonds have coupons high enough to hedge away the credit risk using put options.

1. CUSIP 03938LAX2, maturing 2/25/2022, with a 6.25% coupon, currently asking 98.47 cents on the dollar (6.463% yield-to-maturity)

2. CUSIP 03938LAS3, maturing 3/1/2041, with a 6.75% coupon, currently asking 92.857 cents on the dollar (7.349% yield-to-maturity)

3. CUSIP 03938LAP9, maturing 10/15/2039, with a 7% coupon, currently asking 96.984 cents on the dollar (7.254% yield-to-maturity)

One put option to considering using as a hedge would be the January 18, 2014 $5 puts, currently asking 48 cents. Also, as I mentioned in my article, "A Different Way To Play ArcelorMittal," it might be difficult to find ArcelorMittal bonds offered on your broker's platform, but the bonds are being offered on Bloomberg. Therefore, if you call your broker, he or she should be able to find you the bond you want. One broker that I know does offer these bonds directly to retail investors through its bond platform is tradeMONSTER.

In closing, there are times when investors with long time horizons might find it worthwhile to forgo profits in the present, in order to lock in higher yields than they might otherwise get in the future. If you are interested in executing this strategy on any of the aforementioned companies, please do your own due diligence on their financial profiles. Only you can determine if taking the counterparty risk of purchasing individual bonds is suitable for you. Also, for more information on any of these notes, including additional call or put features, please contact your broker or read the indenture. Finally, even if you don't think this is the ideal time to execute this strategy, keep it in mind in case corporate bond spreads widen and yields go up.

Disclosure: I am long MT.

Additional disclosure: I am long CUSIPs 03938LAS3, 03938LAP9, and 912909AD0.

Source: A Strategy To Get Through Periods Of Uncertainty