| Bear Market Hedging |
Dateline: 6/29/98
There is a great deal of unease over the current state of the market. Some of the pundits who have been crying "bear" continue to cry "bear". But like the little boy who cried "wolf", we don't know whether to believe them anymore. They've been screaming "bear" for so long now, even right through the last several years of the current bull, that we're just sick and tired of their omnipresent negativity. (I'm thinking primarily of the hard core goldbugs here.)
Others seem to have a little more credibility. In particular, I like the approach of Lowrisk.com. They use a computer generated model that analyses the state of the market based on a daily input of significant factors. The model generates a number between 0 and 20 that they use as a signal on what your investment mix should be. (See my feature The Bad News Bears: Part 2 for a detailed discussion of Lowrisk.com)
I noted in my feature of May 11 that the signal strength for the Lowrisk Market Allocation Model had dropped steadily to 12 over the previous few weeks, indicating an increasingly bearish trend. On the 13th it dropped another two points to 10, which moved people using the Lowrisk Graduated Strategy to 50% in cash or money markets. On the 18th it dropped again to 8, which put the Graduated Strategy at 75% cash and only 25% in stocks. But on May 31st, the signal strength gained again to 10, where its been holding steady ever since. The bull ain't dead yet!
Nevertheless, prudence demands being aware of the possibility of a bear market and having a plan of action. My personal plan (since most of my holdings are in mutual funds) is to sell any fund that drops 5% from its previous high and re-invest in other funds that meet my buy criteria. If none do, I keep the money in cash or money markets. But I don't have a plan for stocks. My major holdings are in two companies, Berkshire Hathaway and Microsoft, neither of which I plan on selling anytime soon. (I'm very bullish on both of these stocks.)
But there are other options for mitigating bear markets. An interesting one came across my desk recently with Canaccord Capital's excellent Canaccord 100 profile of Canadian mid to large-cap investment recommendations.
Canaccord's Leanne Bishop sent me a short description of an idea that can "generate high yields, usually makes money in down markets and is relatively low risk". The idea, called Convertible Debenture Hedging, involves the simultaneous purchase of a convertible debenture and the short sale of the underlying stock.
What is a convertible debenture? A debenture is an unsecured bond. Since it is unsecured, it should pay a higher yield than a bond. A convertible debenture is a debenture that can be converted into the common stock of the issuing company at some future date at a preset price.
The proceeds of the sale of the stock covers most of the cost of buying the debenture, thus minimizing capital outlay. This in turn increases the yield on your investment. And if the stock declines, additional money will be made on the short sale.
To better understand how this works, let's look at the example Canaccord sent along. The example used is Hilton Hotels. Data was as of June 12th.
| Last Interest Payment | May 15, 1998 |
| Next Interest Payment | Nov. 15, 1998 |
| Convertible Price | 106.9375 |
| Coupon Rate | 5.0% |
| Maturity Date | May 15, 2006 |
| Credit rating | BBB- |
| Conversion Ratio | 3.0978 |
| Conversion Price | $32.38 |
| Stock Price (HLT-NYSE) | $29.67 |
| Dividend | $0.32 |
| Premium | 14.97 |
| Hedge Ratio | 100% |
Basically this mens you can buy the debentures at a rate of $106.9375 per $100, that you can convert them to Hilton stock at $32.28, and that the stock is currently selling at $29.67. Investing in the hedging scheme would work as follows:
| Action | Amount | Price | Total |
| Buy Convertible Debentures | $100,000.00 | 106.9375 | $106,937.50 |
| Accrued Interest | n/a | n/a | $ 402.75 |
| Sell Common Stock | 3098 shares | 29.69 | $ -91,965.94 |
| Commission | n/a | n/a | $ 459.83 |
| Total Capital Invested | n/a | n/a | $ 15,834.17 |
This shows the actual cost of your investment to be only about $16,000. But what about the return? Here's those figures.
| Interest Earned on Bond | $ 5,000.00 |
| Borrowing Cost on Short Sale | $ -689.74 |
| Dividends Payable on Short Sale | $ -991.30 |
| Net Cash Return | $ 3,318.96 |
This represents a return of 20.96% on your investment! Not too shabby!
This investment is recommended for a neutral or bear market. But what happens if you miscalculate and the market continues to rise? In that case you would have to exercise your convertibility option to clear the short sale. The number of shares shorted (3098) is exactly the number of shares you can convert your debentures into. Neat eh?
Addendum (11:00 AM PDT, June 29, 1998):
After I published this article, Leanne sent me the following note about the downside risk, correcting what I said in the last paragraph. Please note:
From Leanne Bishop: "Remember that the debenture will move with the stock, especially when the share price is above the exercise price of the convertible. At that point, the debenture will usually move dollar for dollar with the stock. There is no necessity to cover the short. What goes against you in a bull market is the premium (In our example, the $15,834.00 invested). That can shrink. So that if you had to close out your position at that time you might not recoup your whole investment. Of course, you have been receiving interest up to then. If the investor can leave their funds in the hedge, over time the interest payments will usually balance out any shrinking of premium.
This is not foolproof, of course. Is anything?!! But, it's an excellent middle-of-the-road investment, between speculative and blue chip."
If you want more information on this investment contact Leanne Bishop at Cannacord Capital. She is also licensed in 26 states to sell securities to Americans.
Bear Necessities (my collection of Net Links on Bear Markets and Bear Market Strategies)
Our Contest
So far there has been little interest in our contest to win an autographed copy of Michael Campbell's Cooking the Books With Mike. This is a shame as it is an excellent book. Perhaps the requirements of the contest are too much for most people, namely add a new topic to our Bulletin Board. So I'll change the parameters to make it easier. If you want to win this book, send me an email and your name goes into the draw. A winner will be declared next week, even if we get no more entries.
Disclaimer: As with all my columns here, I should re-iterate a precaution. I am not a professional financial advisor. I am a financial journalist and editorialist. The views in these columns are my personal opinions.
Investing (Canada) Notes:
Have you checked out The Daily? Links to daily Canadian busines and investment news and commentary.
Newsletter:
You're invited to get my weekly emailed Newsletter in which I let you know what the upcoming article will be and of any significant changes and additions to this site.