For those of you that have been reading this newsletter, you’ll know that we have been writing about why most bonds have made so little sense to invest in over the last few years, given the historically low yields and risks from higher rates and inflation, which has now come to fruition. The average bond fund is down double-digits, which is quite awful given many of them were only yielding 2-3% going into the year. We can’t forget that there were literally tens of trillion of bonds that had negative yields, which seemed stupid then, and now has proven to be quite catastrophic.
A lot of risky investment decisions were bailed out by the Federal Reserve’s zero interest rate policy, which for so long bolstered both bonds and speculative stocks trading at outrageous valuations. Stocks like Peloton, which traded to extraordinary heights during the pandemic when many couldn’t work out at gyms anymore, has cratered by 88%. Some of these “fallen angels” are becoming attractive investment opportunities at much lower valuations. One statistic that I found fascinating is that only 18% of tech IPOs valued at over $10B since 2017 have generated positive returns, and the average return is -32.5%. If you were watching the stock market the last few years, you’ll probably remember stocks trading up 30-100% on the day of their IPOs, very reminiscent to the Tech Bubble, and now most of those gains have turned into losses. While publicly traded companies have taken their hits, many private equity funds have not fully marked down their losses, but just about everything is worth quite a bit less than just 10 months ago, and tens of trillions of wealth has been evaporated. If you liked stock such as Roblox at $100, it looks a heck of a lot better around $40, and the option premiums are quite robust as well.
While I’m hopeful that the inflation growth rate has peaked, I don’t think it is likely we will see rates go down anywhere close to where they once were in the near future. Rates are likely to be higher for longer and this should pressure returns on equity indexes, but also creates opportunities. Now after the decline in prices and coinciding increase in interest rates, bonds can offer a bit more opportunity and diversification. There is also a bigger opportunity in taking advantage of the volatility in the stock market, by utilizing stock options to generate attractive returns with a lower risk profile than simply investing in stocks outright. Below are a few examples of recent trades that you might find interesting.
One example of a pretty conservative bond investment was the purchase of Radian bonds expiring in 2024 with a yield to maturity of roughly 6%. Radian is a leading mortgage insurance company with a Baa3 credit rating with Moody’s. The company has been generating robust profits and we like the stock as well. The company has very strong capital ratios and should remain profitable even in a relatively substantial recession. The industry now uses reinsurance to dramatically reduce the risk profile, which would protect capital and book value during a major housing recession, allowing the company to keep writing new business when it is most profitable, as prices would increase dramatically. This bond matures in just over 2 years and for investors seeking a nearly 6% per annum return without stock market exposure, this is an example of a low-risk and short duration opportunity that might be a good fit. The short duration is important because it reduces the interest rate risk in comparison to longer duration bonds. One can make it more attractive using leverage, but we won’t get into that here.
Another conservative trade is on one of our old favorites, Cleveland-Cliffs. We sold a January 2024 $10 put for about $1.05, with the stock trading at $18.89. This investment produces an 8.4% annualized return, but the key is looking at the risk profile. You would make that profit at expiration, unless the stock drops by 47%. Your breakeven is even more attractive at $8.95 per share, which means the stock could drop by 53%. Now of course we can dial up the target returns by either selling puts closer to the stock price, or using leverage via a margin-enabled account, but I like to provide conservative trade examples that I believe will achieve higher returns than the overall market, with far less risk in our general newsletter.
Keep in mind that many of our options expire in January of 2023, so we often get that nice boost towards the end of the year as time decay accelerates. Trades we have discussed before such as Lending Club have been nicely profitable, but still offer attractive returns between now and then. The $10 January LC put options, which we have sold for many different prices from $1.80 to $1.15, are still going for about $0.65, with the stock trading at $14.38. This means that assuming the stock expires above $10 in January, we will make 7% on these positions, which is 17.5% annualized. Our portfolios are filled with these types of investments, which is why I’m quite confident we will finish the year strongly barring something insane happening. LC could drop by 30% and we would still get the full target profit, so we have a very strong margin of safety!
I hope these examples are helpful, as I know that options can be complicated. These are strategies, which 99% of financial advisors are simply not willing or able to offer you, that I’m proud to say have been a pillar of our business for over a decade now. I believe we are likely entering a much more rangebound market environment for the next 5-10 years, where this will be a huge advantage of attaining superior returns, which wasn’t necessarily the case in an era of easier money and robust stock market returns. If you have any questions, or want to take advantage of some of these opportunities, please don’t hesitate to contact me! Below are my latest research reports on the three names mentioned: