Blue HavenBonds

Conservative trades I’m making right now

By December 12, 2020 No Comments

We’ve previously written about cash replacement trades, which are an investment that replaces the role of cash for a short period of time. These investments are typically extremely safe. And historically, they’ve provided yields between 1-2%, making them great replacements for cash, which earns zero. The problem is that many of the ETFs we use for cash replacement trades, such as ICSH and IGSB are now yielding less than 1%. 

Cash replacement trades

While they remain very liquid and safe products, the yields on ICSH and IGSB are less attractive than they were 12 months ago. As a result, we’ve been considering if we can slide our risk scale up very slightly in order to achieve a reward (yield) that is proportionally greater. For example, think of risk and reward on two separate 1-10 scales, where 1 is least risky and 10 is most risky. Usually risk and reward are equal, a risk of 1, or low risk, is usually compensated with a reward of 1, or low reward. But, is it possible to take our risk from a 1 to 2, while bringing our reward from a 1 to a 3? We’d certainly like to think so.

Along those lines of thinking, we’ve been allocating some cash to some typically more conservative trades, though ones that are admittedly not quite safe enough to be deemed “cash replacements.” MBB, for instance, which is generally thought to have the same credit quality as treasury bonds, is currently yielding 1.20%. That’s far better than the 0.40% that ICSH is currently yielding.

However, MBB, does come with greater interest rate risk than ICSH, as evidenced by its duration of 2.07 and convexity of -2.15. But with the Fed’s recent communication signaling a “lower for longer” interest rate policy, we’re comfortable accepting those risks right now. GNMA is another ETF similar to MBB, but is a little bit safer. Duration is 1.44 and convexity is -2.48, but the yield is a little lower too at 0.90%. :

Thinking differently about yield

Realistically, if we want more yield, we have to look elsewhere. And in this case, I’m going to use a liberal definition of yield. Most investors think of yield in terms of interest. For example, a $100 stock paying a $5 dividend offers a 5% yield. But, if that same $100 stock were expected to rise to $105 over the next 12 months, I would say it still offers a 5% yield. It’s just a yield that will be realized through capital appreciation and not interest.

Enter buffered ETFs (again)

There are a number of buffered ETF options that are currently offering attractive conservative entry points. What I like about these is they can function like fixed income products. This is due to the fact that, in many cases, the index return is above the capped return, but the buffered ETF isn’t yet at the cap. Take BFEB for example, whose outcome period ends on January 31, 2021. BFEB started its outcome period 10 months ago with a 13% cap on gains tied to the S&P 500. So far over that period, the S&P 500 has risen 13.59%, or 0.59% above the cap. BFEB, however, is only up 9.57%, which means there’s still about 2.30% (net of fees) left for the ETF to rise if the S&P 500 stays flat between now and January 31, 2021.

An investor can buy BFEB today and “lock in” that 2.30% return. The risk of course is that there is still time before the outcome period ends, and if the S&P 500 were to decline, BFEB could lose value. However, BFEB has a bit of a cushion before you’d start to lose out on that 2.20% return. The S&P 500 would need to fall below 3,644 to start eating into that 2.20% return. That’s calculated by taking the S&P 500 starting point from the beginning of the outcome period (3,225) and multiplying it by the cap (13%), which equals 3,644.

To figure the fair value for BFEB right now, just take that same 3,225 starting point for the S&P 500 and multiply it by BFEB’s current return (9.57%), which equals 3,536. This tells us that an investment in BFEB from the current price will only lose money if the S&P 500 is below 3,536 at the end of the outcome period (1/31/2021). Therefore, BFEB in effect has a 3.50% buffer against current losses in the S&P 500, as that is the amount the index needs to fall for BFEB to be lower than its current price at the end of the outcome period.

Buffered ETFs can provide cash replacement trades right nowOther alternatives

There are other buffered ETF options that can serve similar functions to BFEB given their current pricing and remaining caps versus the S&P 500. BJAN and BMAR for instance, each offer 1.38% and 1.93% returns, respectively. BJAN’s S&P 500 return is right at the cap, leaving it the least wiggle room and smallest buffer against losses. However, there’s only 20 days left in the outcome period. BMAR has a lower baked in return than BFEB and longer to go until the end of the outcome period. However, the S&P 500 is currently 8% above BMAR’s cap, giving it higher odds of paying out its remaining 1.93% cap versus BJAN or BFEB.

Using buffered ETFs for conservative trades this way does require active management and a tactical approach. But we like the flexibility they provide in that you can choose from a number of different scenarios that best suit your personal preferences. Yet, even more stores of value for cash reside in preferred stock ETFs such as PFXF. Currently yielding more than 5%, PFXF is yielding a lot more than you can find in traditional dividend paying ETFs. An instrument like PFXF will be more volatile than a government bond and it may be best paired with bonds that will outperform in a broader market downturn, such as long-term treasury bonds.

Staying true to form

When looking to keep cash safe your best bets are to focus on liquidity, safety, and a fixed return. In that regard, MBB and GNMA are our favorite conservative trades in the market right now. Both are pretty safe and yielding about 1%. But understand that to get that 1% yield, you are still taking on some risk. If you want as little risk as possible, then an instrument like ICSH is probably your best bet. Just keep in mind it’s currently yielding less than 0.50%.

If you want to capture more than 1% you really don’t have any choice but to accept even more risk. Importantly though, unlike Drake, you don’t have to go from 0 to 100 on your risk scale just to get a better return. Buffered ETFs that haven’t yet reached their capped returns, such as BJAN, BFEB, and BMAR, offer a unique way to possibly generate 1.25-2.50% ROI in a short period of time. Additionally, a preferred stock ETF like PFXF can offer even more at 5%, but it shouldn’t be considered a low-risk investment. Though it has traditionally been less risky than stocks.

Just two years ago you could go to your bank and lock in a CD paying 2.50-3.50%. Or you could park your money in a high yield online savings account from Ally and earn 2.50%, basically risk-free. Well, those rates have been on the way down for some time now, and the Covid crisis has essentially brought them towards zero. Maybe rates will go back up soon, or maybe they won’t. But there are ways to get yield on your cash right now if you’re willing to do your homework and consider being tactical.

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