Many investors, especially retirees, understandably are focused on generating income from their investments. Historically, bonds have been one of the best ways to achieve that, with less volatility than equities. While history can be a fantastic guide to what can potentially happen in the future, looking at recent data on fixed income returns could not be more misleading. Record-low interest rates and global quantitative easing have driven bond yields to historic lows. The upside is paltry, and the downside is massive for future bond returns.
To put numbers to that, the BAML U.S. High Yield Index, has an effective yield of 5%. The BAML U.S. Investment Grade Bond Index, has an effective yield of 2.61%. These numbers are simply staggering as those yields are before the very real costs of inflation and defaults. Remember that unlike stocks, bonds do not grow in value, like a business’s earnings stream might. The risks are completely asymmetrical, as any increase in rates, inflation, or spread to Treasuries, would lead to substantial losses. These losses could easily wipe out years of income from these paltry rates.
The reality is that if you are invested in bond mutual funds and/or bond ETFs, you are not only invested in these types of bonds, you also likely own government bonds at negative interest rates. That is the danger to funds in that you usually don’t know what you own specifically. Most people wouldn’t buy these bonds when looking at the individual characteristics, but in a fund one just piles into the abyss. When interest rates go lower, these investors are bailed out, as that helps the bonds gain in value. At some point…..rates must go up, and if there is a whiff of inflation, it could happen far sooner than most would believe.
One stock that we really like a lot, ALLY Financial, dropped by about 11% after an acquisition of a credit card company spooked some market participants. The stock is trading at around $28.33 per share, which is about 7 times earnings. The dividend on the stock is now 2.36% and has been growing by 23.86% on average over the last 3-years. In addition, the company is buying back stock representing about 10% of its market capitalization, at these discounted prices. This is clearly more attractive than any of these bonds we can buy and the stock has upside to at least $40.
As another example if we wanted to even be more conservative, we could sell the $27 put expiring in January for about $2.50, or $250 per contract. This is a 10.2% return on the maximum risk of $2,450 ($2,700-$250=$2450), assuming the stock expires about $27 at expiration, which is less than a year. Our worst case scenario would be owning this deeply undervalued stock at a greater than 50% discount to our estimate of intrinsic value. These types of short-term selloffs are exactly why we sell puts in the first place. Now if we have already sold a $27 put for $2.00 when the stock was higher, we might be down $50 per contract, but the dynamics of the investment stay exactly the same. We are happy to either own the stock or let the options expire, but by selling puts we were able to manufacture a greater margin of safety than would have existed had we just bought the stock outright.
Over the last several years, we have closed out thousands of options trades on ALLY at strong profits, representing many millions of dollars of capital. If we had just owned the stock only, we likely wouldn’t have sold, as the stock hasn’t quite traded up to our estimate of intrinsic value. When the stock takes a dip, we are in a situation to take advantage, without bearing the whole brunt of the selloff as we would when we just own stock outright. Of course, as we always say, the full benefits of these strategies only show as time elapses on the options. Even if the stock were to close exactly where it is now, the time value decay would add a considerable percentage of money to our account value. All we need to do is let the options do their thing and add when possible, as the opportunity is quite good.
Lastly, I’ll mention that there are a lot of weird things going on in the market and emotions/greed are running high. Stocks such as Tesla, Virgin Galactic, and Beyond Meat are up 119%, 223%, and 67%, respectively, YTD. While these might be exciting businesses, these stock valuations are enough to make AOL.com blush during the Tech boom. Remember that price is what you pay, and value is what you get. It is fine to speculate, but unless there is a fundamental reason behind that speculation, it often is a form of gambling. I see major parallels to recent bubbles that collapsed in Bitcoin and in Cannabis stocks, both of which we wrote about extensively.
Below are our three latest research reports, which I hope that you will enjoy!