These days, if you are an income investor, it's tougher than ever to guarantee a decent return on your money. Inflation is low, but treasury bond, municipal bond and cd rates are even lower.
Officially, inflation today is running at about 1.5%. However, this figure is in considerable dispute, and there are strong arguments indicating that the real inflation rate is closer to 4%.
Simple strategies no longer work. The highest 1 year CD rates run about 1.25%, and two year treasuries pay 0.64%. So many retired investors are facing a life challenging conundrum: how to generate enough income on their savings to keep their heads above water.
To generate a real positive return of income without unacceptable risk requires creativity, and yes, the complexity of using derivatives to hedge out what otherwise would be unacceptable risk.
One such strategy is shown below, based on a recent bond offering at the time of this writing. The following is a strategy to realize returns of 5% to 7% with great safety.
Let us assume you have $50,000 of savings to allocate. At the time of writing, you could buy $47,000 of a JPM 30 yr/2 yr steepeners at 92 cents on the dollar.
This pays you a coupon that varies but is based on the difference between the 30 year rate of interest and the 2 year rate of interest, multiplied by a factor of 7.5. When that multiplication yields an amount greater than 10% (which should often occur) , your coupon is capped at 10%. Since you would be buying this bond at a discount, your real return will be higher than the nominal yield.
The following table shows how that could work out at different interest rate assumptions, reflecting possible GDP scenarios:
|30 year||2 year||difference||factor||result||cap||actual||real yield|
Historically, the 30 year treasury rate usually runs a few percentage points higher than the 2 year treasury rate. This reflects investors' preference to demand higher rates of return the longer they tie up their money lending it out.
Rate inversions, where the 2 year is higher than the 30 year, are uncommon, and when they occur rarely last much longer than 6 months.
These correspond to periods of government tightening, usually when an overheated economy causes the central bank to worry about rising inflation. The central bank will then raise short term interest rates to reduce credit to the economy, and it usually takes a few months for long term rates to adjust up, as they must. (If you could always borrow at long term and invest higher for the short term you would quickly become rich. Everyone would do that, causing long-term rates to rise higher than short-term rates.)
So over a 20- to 30-year period, we would expect this steepener bond to have only rare occasions of low or no coupon payments.
Historically, this is exactly what has occurred, as the following graph shows. In boom times, the Fed starts to tighten against impending inflation, sending the differential down. In depressed times, the opposite occurs.
Of course, history does not HAVE to repeat itself, but we believe it will. Over the next 20 years, we expect the difference between long-term bonds and short-term bonds to run at least 1% and often 2%.
If that occurs, our average return on steepener bonds will average between 8% and 11%. Pretty darn good, given these low yielding times.
If an investor were only to buy this steepener bond, without any hedges, the risks of this investment are threefold:
- If interest rates rapidly rise so that long-term rates eventually surpass the maximum this bond can pay (10%), this bond could trade below par. This means reselling it in the secondary market would yield less than the original principal paid, offsetting any coupon gains.
- If the stock market drops by 50% or more, the bonds do not pay any interest unless or until the bonds cross again above that threshold and remain there. This is a real risk, to which we ascribe about a 10% probability. Past such downturns in the US markets have never lasted more than 1 or 2 years, even in the Great Depression, but in the case of Japan, a similar crash took 4 years until a partial recovery occurred sufficient to resume the flow of payments from this type of bond.
- If the stock market remains at a 50% drop from today's level 30 years from now, this bond will be redeemed at a fraction representing the amount the stock market index has fallen off of its initial starting point value. Theoretically, a bond holder could lose 50% or more of his principal.
Let's address the first risk, a rapid rise in short-term interest rates. Such a rapid rise is nowhere close to being on the horizon, in our view. In fact, the global economy shows bigger risks of multi-year weakness than multi-year strengths.
Moreover, long-term rates have never rapidly risen from current levels (3%) to more than 10% quickly. Even a rapid series of short-term hikes by the central bank -- temporarily yielding an inverted yield curve and 0% interest under this bond's terms -- should quickly give way to plunging long-term bond values and rising long-term bond rates. This steepener bond would likely quickly max out at its 10% return.
At that stage it would be trading close to or above par and could be sold profitably. In fact, these steepener bonds, which can be called by the issuing banks at the end of any month, are most likely to be called in just these situations. Since we are acquiring them at a discount, and they would be called at par, we would be locking in a profit.
Now let's quickly skip to the third risk. Frankly, we do not see this as a risk sufficiently likely to even be worth worrying about. A stock market trading a 50% below today's value in 20 years, despite the effects of inflation on stock prices, let alone real economic growth, is not imaginable, and has never occurred in history.
Is it possible? Of course, but then we are probably talking about a situation of war, pestilence and famine of such monumental proportions that your investments are the least of your concerns.
So let us address the most likely risk, the second, that of a severe drop in the stock market, and develop a hedge to protect against its effects. We would buy a long-term put spread on the SPY, which is an ETF that mirrors the S&P500. The S&P500 is index upon which a 50% drop would trigger a temporary cessation of bond payments, so the SPY presents us with a perfect instrument of hedging.
At the time of writing, 15 contracts expiring in December of 2017, the longest period for which we can currently buy contracts, can be bought for $3666 for 18 months of protection. This works out to $2444 annually or 4.82% of our total financial outlay ($47,000 for bond and $3666 for options).
This put spread starts making money at index prices below $203 and maxes out at $5500 per contract or $85,000 for our 15 contracts. Please refer to the graph.
Time is our enemy here, as the options expire in December of 2017. The more time passes, the less the contracts are worth at any given price point below $203.
By combining our hedge with our bond purchase, we expect to see the following results in different economic scenarios. (In the table we are assuming average bond returns of 7% and valuing the options positions at 1 year and at expiration, respectively. We are assuming we do not sell the bond even at low values, since we have the option protecting our investment. The options positions would have to be reestablished every time the current contracts expire, or about every 18 to 24 months.)
|Scenarios:||SPY +50%||SPY +20%||SPY +0%||SPY - 20%||SPY - 50%||Assumption|
|bond income||$2800 - $4700||$2800 - $4700||$2800 - $4700||$2800 - $4700||0%||Bond is not called and pays no coupon|
|capital gain / loss||$3800 - $4200||$3800 - $4200||$0||$0||0%||Bond yield outperforms other fixed investments so premium rises to par over 2 years or 4% year.|
|option cost||($2444)||($2444)||($2444)||($2444)||($2444)||Annualized cost of options positions|
|option gain||$0||$0||$0||$519||$27000||At 274 days elapsed, slightly increased volatility|
|option gain||$0||$0||$0||$519||$27000||At option expiration (543 days) independent of volatility|
|Net income||$4256 - $6256||$4256 - $6256||$356 - $2256||$875 - $2775||$24.556||At 274 days of elapsed time (arbitrary value)|
|In Percentage||8% - 12%||8% - 12%||0.60% - 4.3%||1.7% - 4.4%||48.8%|
|Net income||$4256 - $6256||$4256 - $6256||$356 - $2256||$356 - $2256||$24.556||At 543 days of elapsed time (arbitrary value)|
|In Percentage||8% - 12%||8% - 12%||0.60% - 4.3%||1.7% - 4.4%||48.8%|
As you see this bond / option combination performs well in a rising economy, yielding between 8 and 12 percent, does better than most CDs in a flat or negative economy with a yield between 0.60% and 4.4%, and does wonderfully in a stock market collapse, yielding 48% in the year of the collapse.
It is important to note that the yield in subsequent years will not be repeated. Depending on whether bond values have risen or fallen and by how much, it might be attractive to close out all positions at that juncture. Presumably the bond would be selling at some discount, perhaps in the 70%-80% range resulting in a capital gains loss of $6000-$10,000 on the bond. This would still leave us with gains of $10,000 to $18,000 on our original investment in less than 2 years, a wonderful return.
Or depending on worldwide macroeconomic parameters, it might be more attractive to hold this bond for its future appreciation back to par and future stream of income, and to sell calls spreads (at strikes above the threshold for payments) in the meantime to generate income.
Disclaimer: none of these values can be ascertained with certainty, as too many variables are at play here. These are rough approximations of the most likely values of the different instruments based on our best calculations. These calculations cannot be guaranteed, and may be erroneous. This investment could lose money, and gains cannot be guaranteed.
There is no doubt this is a complex combination. But we think the superior yield makes it worth the added complexity and the need for adjustments every couple of years.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We currently own the type of bonds mentioned in this article for our investors and hold hedged positions described herein.