Description

Flip a coin. If it is heads then go long junk bonds. If it is tails then go short junk bonds. I am not sure which position will be right but it is cheap to make either bet so Im calling this strange idea of randomly choosing to go long or short the same asset a value. Whichever position you take the trade is similar because it is based on the same mispriced option — long-dated calls on the junk bond etf, JNK. The underlying etf, JNK, trades at $41.40. The calls on this etf with a $42 strike expiring in January of 2016 trade at just fifteen cents (ask). You want to buy those calls. Depending on your coin toss you may want to short the underlying etf, also.

Coin flip

Heads: Long junk bonds. You expose your portfolio to only the upside price movement of $82k worth of junk bonds for the next 1.6 years for a mere $300 one-time premium. $300 is the most you can lose. The media and the gurus say junk bonds are expensive but $300 to control $82k worth of any asset class is just too good to be true. Fundamentals be damned, stuff happens. You will make money if (1) the gurus are too early, (2) market volatility increases, or (3) interest rates go down across the board.

Tails: Short junk bonds. Youll be in good company and I heartily recommend this side of the trade (just as much as I recommend the other side I have no conviction). Short the actual JNK etf and go long the January 2016 call. You will have to pay the coupons but you will lock in your downside. If the coupons are too much negative carry for you to support, then you can buy a few muni-bond CEFs with similar yields. Youve created the perfect trade betting against the thin corporate credit spread. If you choose to bet against junk in this manner you also pick up a nice hedge for your equity portfolio because the JNK etf has had a +.78 correlation to stocks over the last 5 years not a bad way to lower your market exposure.

But never say never a lot QE can happen between now and January of 2016. While the nominal yield on junk bonds appears to be stretched, the spread over similar duration government bonds is actually not at an all time low. If the spread comes in by a 100 basis points it will still not be an all time low and you will turn your $300 investment into $18k. If the spread goes the other way you dont lose a penny more than $300. Junk credit spreads in Japan are at around 200 basis points.

The implied volatility of this call is 4.5%. If the call price ever reflects actual volatility or just the level of volatility that is implied in the put (16%) then you will make $4000 with your $300 investment no change in spread required.

Here is the crux of this trade where else can you get this kind of exposure to any asset class for this cheap of a price. You may not like the asset class but this cheap and it is as contrarian as it gets: