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Bond Traders Take On The Stock Market


A few decades ago, I joined Merrill Lynch for what turned out to be a 30-year career.


Although the firm's business had always been geared more toward stocks, a couple of us decided to specialize in bonds, because interest rates were high at the time, and it wasn't hard to convince investors that a double digit return in bonds might be more attractive than taking stock market risks. 


In the early 1980s, the prime rate hit 20%, the 30-year Treasury  bond yielded 15%, and you could find good quality, double-tax free municipal bonds paying 13-14%. To those paying federal and state income taxes exceeding 50%, those munis represented a taxable-equivalent annual return of nearly 30%! 


With those high tax-free yields available, and several accounting firms sending us their clients for bonds, by the time I retired our own clients included many of the "Who's Who" of corporate America.


However, despite the great returns delivered by bonds during those years, there eventually came a time when a few of our clients wanted to get into the stock market. This presented a problem.


The record was clear that the vast majority of "stock-picking " strategies and funds on Wall Street consistently failed to even match let alone beat the market. Worse, individual investors and "pros" alike invariably got caught in every bear market and suffered losses, which at times were severe.


We could not afford to have that happen to our bond clients. As close as we were with them, and as well as we were doing in the bond market, we knew that would quickly be forgotten if we put them into some money-losing stock fund or scheme.


Index funds? They weren't the solution either, since they also go down with the market.


We had to find a better way, one which would allow our clients to capture the stock market gains they were looking for, but without subjecting them to the usual stock market risks. 

The Bond+Option Solution

By combining some of the higher yielding bonds which were available in those days with standard S&P 500 index options, we were, in fact, able to realize any annual gains in the S&P...and avoid any annual declines.


It worked like this...


A "call option" which allows the investor to capture 100% of any appreciation on $100,000 worth of the S&P 500 over a 1-year period might cost roughly 6% or $6,000. So if the S&P was up, say, 15% at the end of the period, the call option would expire with a value of $15,000.


Let's also assume...as was often the case years ago...that good quality bonds, CDs, Treasurys and the like maturing in 1 year paid at least 6%.


Instead of taking the client's $100,000 (or any multiple thereof) and putting it into some stock picking strategy or fund...which was almost sure to underperform the S&P at best and lose money at worst...we would invest $94,000 in the fixed income instrument and $6,000 in the call option. 


Since the interest earned on the $94,000 would generally cover the cost of the call option, the original $100,000 investment would end up being worth at least $115,000 at the end of the 1-year period, thereby capturing all of the S&P's gains. *

On the other hand, if the market declined or even crashed, the investor would still get back his original $100,000, thereby losing nothing!


These were two things that no stock-picking strategy or index fund could promise!

                                         

When Interest Rates Are Low

What made the "bond/option" technique work without a hitch years ago was the fact that the interest from a 1-year fixed income instrument easily covered the cost of the 1-year call option. We could simply buy the bond and option and not have to do anything else for 12 months...then do it again for the next year when those two instruments matured/expired. But interest rates were not always high enough to do that back then, as they are certainly not high enough now. So a little additional work was necessary.


To raise some additional cash, a few above the market ("out of the money") short term options were sold during the year. This required no additional investment, as we were selling not buying, and the short term options were supported by the 1-year option. (For details, see "Going Forward")


 The bottom line was that even in the lower interest rate environment, the results were still approximately the same: The investor was still able to capture most or all of any S&P gains during the year, yet lose little or nothing if the market declined or even crashed.


                                      ********************************


James Terry

Scottsdale, AZ