Maintaining Market Exposure through Traditionally Ultra Safe Asset Classes

I find I can’t bring myself to watch the business news anymore in the mornings. Everywhere I look, panelists and pundits alike seem to be lamenting over the increasing complexity required to maintain a portfolio in the modern market.

Whereas statistical and technical alchemy used to be the lectures of the old-guard of investment gurus, today’s reporters seem focused on discussing some cryptic art of industry allocation that extends beyond what common sense would dictate. (Of particular interest, I once heard an analyst from a set of analysts from a number of respectable firms agree that gold acts as a hedge to inflation, interest rates, and bond yields, all within the same 30 minute session…an inherently contradictory statement).

Essentially, these programs would have you feel as though it is only possible to realize returns from the market by carefully adjusting your portfolio on a regular basis to accommodate shifts in the economy that favour specific industry sectors. While there is a great deal of validity towards this school of thought, taking it to such extremes as rebalancing your industry allocations on a daily basis makes for more entertaining television than it does retirement savings. Why can’t we just on a few intelligent positions, and ride them out towards a calculated payout that is appropriate to the consistent amount of risk that we’re each individually comfortable with?

Let me introduce you to the concept of market neutrality. In its truest form, market neutral portfolios take on zero portfolio risk by maintaining an equal amount of short and long positions. They tend to then profit by strategically choosing positions that will gain or lose more than others. For example, if a stock is expected to gain more than a competitor over a given period, a neutral investor would short the competitor to hedge against market and industry relevant risks, and benefit from the company’s ability to out-perform its competitor by buying the stock.

The spread between the rates of change of the two positions is the investor’s profit. Sound confusing? It is, and that’s one of the reasons why good market neutral fund managers are excellent people to engage to manage a portion of your wealth…if you can afford them, that is. If not, let me show you a simpler strategy that is accessible to any retail investor with an adviser.

A convertible bond is a debt security that collects coupon payments over a given period of time. As a fixed-income investor, I personally love the safety provided by a predictable cash flow, and so I’m already happy with the way things are looking for this opportunity. However, a convertible bond also maintains a ‘conversion clause’, which, if executed, allows me to exchange the bond in for a set amount of equity shares. What does this mean? Simply put, this security gives every-day investors exposure to both fixed-income, and capital gains, at the same time.

I won’t get too much in the math here, but I want to illustrate exactly how it is that you can benefit for this as an investor by explaining how it is that the price of a convertible bond is determined. Firstly, we value the bond aspect of the security in according to a simple present value calculation. Secondly, we run a series of calculations to factor in the value of the security if it were converted into equity at the stock’s current price.

If this second value indicates that an immediate profit is available through conversion, the premium is usually included in the convertible’s price. Lastly, the market will factor in a premium or discount in accordance to what sort of expectations the market has for the underlying equity. If the stock is expected to increase in the future, the convertible will trade at a premium (and vice-versa).

Convertible Price = Coupon PV + Conversion Premium + Expectations

Now if we were speculators, we’d begin to enter an almost ridiculous discussion about the different kinds of statistical arbitrage strategies that can be employed around convertible securities to make massive amounts of profit in an extremely short period of time….but we’re not speculators, and we’re not sophisticated enough to compete with hedge-funds, so we’re not. Instead, we’re going to look at how it is we can take on as little risk as possible by holding these securities to maturity. Specifically, we are going to look at these securities as a reasonable personal investor.

We’re going to purchase these securities with the help of an investment advisor that looks into the ability of the underlying company and industry to produce a return over the period of the bond, and we are going to accept the bond as a cash-flow instrument for its entire duration. As a reasonable investor, this is the only amount we’re interested in, the cash flow. However, as a reasonable human being, we understand that upside potential associated with the underlying company, because we believe in the firm we have invested in. So our hypothetical investor purchases a convertible bond. Now, one of four things will happen:

  • The investor makes money on the bond coupons payments, and cashes out at the end of the period. The income was exactly as planned, and our investing goals were met as planned.
  • The company outperforms expectations over the long-term, and the current equity premium is now above what was initially factored into the stock premium. The investor can now convert the bond into equity, and benefit from the large upswing of the company’s stock as if the investor had owned the stock all along. A greater benefit than originally expected in realized.
  • The company fails to meet performance expectations over the period of the bond, and the stock falls a reasonable amount. The investor earns the coupon payments as was originally planned, and the investor’s portfolio goals are all met.
  • The investor’s analysis of the underlying company was flawed, and the company defaults on the debt. A loss is incurred, likely due to an unforeseeable risk that will cripple the company (if not completely destroy it).

At risk of over-emphasizing the point, our broad analysis of this sort of security shows a clear benefit to its ownership over other asset classes. More upside exposure than a bond, and more safety than a share, these convertibles truly are a breed of ‘supper-asset’.