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Synthetic bonds in IRA?
Old 05-14-2015, 11:39 AM   #1
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Synthetic bonds in IRA?

I am very anti-bond right now with the ultra low rates and very real threat of interest rate risk for longer term bonds. I don't mind cash with the current low inflation (cash including breakable CD's, I-bonds, etc.)

If you want to stay something around 60/40, and don't want to go with bonds, then having 40% in cash seems like throwing away money. Very little cash like investments will even keep up with the current low inflation, giving you a negative real yield that the 60% in stock has to overcome.

Enter my idea of synthetic bonds, or better known as deep LEAP put writing on a major index like SPY for a portion of your investments. I am not saying you should write puts against your entire stock holding, but only write enough puts such that your cash portion has a positive or zero real return.

An example $1M portfolio consisting of 60% stocks, 20% puts, 20% cash.

Inflation rate 3%, cash yielding 2%

Write $200,000 worth of cash secured puts against SPY at $190 strike for Jan 2017 expiration and collect $13 (6.8% return, ~4% annualized)

Say the stock market plus dividends has a return of 6%. Your total return would be 0.6 * 6% + 0.2 * 4% + 0.2 * 2% = 4.8% or 1.8% real.

A 60/40 portfolio with the 40% invested in 2.2% 10 year treasuries would have a return of 0.6 * 6% + 0.4 * 2.2% = 4.48% or 1.48% real. This represents a 17% smaller return on investment than the 60/20/20.

Risk wise, the market would have to drop 10% before you were assigned the puts. You could view this as auto rebalancing

The 10 year treasury bonds have some risk of interest rate increases, and have very little upside if rates decrease. The 20% cash you hold in the 60/20/20 portfolio has no risk, not even from inflation, since it is getting the benefit of a higher overall return than the bond portfolio.
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Old 05-14-2015, 12:42 PM   #2
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Part of the reason I hold bonds (and similar) is to have something with low correlation to the equity market. Your put strategy does not have that, so I would be leery of making it a bond substitute. I have been subbing cash/CDs, low duration foreign bonds, and merger arbitrage funds for bonds.
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Old 05-14-2015, 01:14 PM   #3
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Originally Posted by brewer12345 View Post
Part of the reason I hold bonds (and similar) is to have something with low correlation to the equity market. Your put strategy does not have that, so I would be leery of making it a bond substitute. I have been subbing cash/CDs, low duration foreign bonds, and merger arbitrage funds for bonds.
Do they really have a low correlation with the equity market though? Take the 10 year Treasure at 2.2%. What if rates were to rise 1% over the next couple of years? This would cause a drop in the stock market as bonds would become more attractive and a drop in the current bond market (the ones you own) because nobody would want your 2.2% bonds when they could buy 3.2% bonds.

Cash has a low correlation with the equity market AND zero interest rate risk. The puts have a higher correlation with the equity market but much less risk than going higher in equities because bonds are unattractive (some people are going 80% or more equities because of the low bond interest rates)
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Old 05-14-2015, 02:43 PM   #4
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Do they really have a low correlation with the equity market though? Take the 10 year Treasure at 2.2%. What if rates were to rise 1% over the next couple of years? This would cause a drop in the stock market as bonds would become more attractive and a drop in the current bond market (the ones you own) because nobody would want your 2.2% bonds when they could buy 3.2% bonds.

Cash has a low correlation with the equity market AND zero interest rate risk. The puts have a higher correlation with the equity market but much less risk than going higher in equities because bonds are unattractive (some people are going 80% or more equities because of the low bond interest rates)
Treasuries tend to have low correlation with equities when it counts: when the commode hits the windmill. As for the rest, I don't want to bear interest rate risk so I have largely tossed traditional bond funds for alternatives.
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Old 05-14-2015, 09:01 PM   #5
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... Risk wise, the market would have to drop 10% before you were assigned the puts. You could view this as auto rebalancing ...
If the market crashes hard as it did in 2008-2009 and loses 50%, your $800K stock+option becomes $400K stock. Together with your $200K cash, it's an 67/33 AA.

In a milder crash of 25% equity loss, your $800K equity+option becomes $600K, for an AA of 75/25.

Hey, that's more than rebalancing. It's tactical AA!

One can then think about call options to unload the "excess" equity in the AA when the market recovers. Buy low/sell high, how can it go wrong?

PS. Actually, the resulting stock AA is a tad higher than the above simple calculations, because the option is exercised at 10% discount from the current stock price.
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Old 05-15-2015, 07:38 AM   #6
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While I share your concern about low rates and interest rate risk, my solution has been to focus on interest rate risk through a combination of online savings for cash, CDs (thank you PenFed!), maturity date investment grade and high yield bond funds in lieu of CDs, foreign bond funds and merger arbitrage funds. As of the last time I looked at it in mid-November of 2014, the weighted average yield was 2.6% and the weighted average duration was 2.7.
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