Uncovering any type of value has been tough in this market.
Stocks are trading at their highest multiples in years after nearly a decade of rising stock prices. Even with the 2008 financial crisis, the S&P 500 has had just 1 negative year in the last 15 – a feat that has happened only once before in history (1982-1999 is the only other 15+ year period with only 1 negative year). The CAPE ratio is at a level above 30, a level which has never produced positive 10-year returns. The S&P 500’s dividend yield is now below the 10-year treasury, something that last occurred a decade ago.
Historically, at times when stock markets have been so expensive, bonds have offered yields to help reward patient investors unwilling to invest in an expensive stock market. Before 2008, 10-year treasury bonds yielded 4.5%. Prior to 2000, that same bond yielded over 6.5%! But today, bonds are offering generational low interest rates that even in today’s low inflation environment yield real returns around 0%.
But getting out of your comfort zone may prove worthwhile. Below we will look at a publicly traded third party trust that holds high yielding bonds in a specific company. However the trust is valued 38% less than the market value of the bonds that are within the trust.
We will then explore the ways to hedge our investment to eliminate credit risk in its underlying holdings. For large investors this is easy to do, but small investors need another option. We will use the findings of a 2011 academic paper to construct a put option position to completely hedge our position, theoretically leaving us with a 6.8% net annual yield and hopefully a one time 38% gain – completely independent of the general stock market’s return.
