Informed Tip of the Week: To (sort of) go along with the safety theme, how about I highlight some easy home maintenance tips you can do to reduce your risk of an insurance claim.

Nearly three years ago I wrote an article suggesting the safest trade out there was to go long Exxon stock and short Exxon debt. This was a long term call. A very long term call – 27 years long.

And I got the timing pretty wrong. Exxon stock declined over 50% in the next seven months. But it didn’t matter. That was precisely the point. Sure, it would have been better to nail the timing but there was so much alpha in this trade, that you could get the entry point that wrong and still win.

So I thought it was time for an update as there are some pretty interesting lessons worth repeating.

A Refresher

Let’s review the original trade premise. Exxon stock was at $70 and had a 5% dividend yield. At the same time, Exxon had 30 year debt due in 2046 with a 4.1% coupon. In other words, you could buy the stock, short the debt and make more on the dividend than you paid in interest.

But, it was better than that. The debt traded at 118! That means you could buy $118 of stock relative to $100 par of debt. Thus, for every $100,000 par of debt you shorted, you could buy $118K of stock and make $1800/yr in positive carry (the dividend – the interest).

The best part was you could do this for 27 years. Thus, you had a free 27 year call option on Exxon and you were getting paid for it! There were some risks (e.g. a dividend cut) but they were small, certainly compared to the upside. It was about as perfect a pair trade as you could devise.

Also, this wasn’t only an Exxon thing. There were a number of other companies with this opportunity, but Exxon had the biggest disparity of those I found.

What Happened Next

As mentioned, the stock proceeded to fall over 50% in the coming months as energy stocks fell even further out of favor with oil briefly going negative. But you still had over 26 years left for the stock to rally back. And it didn’t need nearly that long.

Two and a half years later, Exxon stock has rallied all the way to $87, up 25% from the original recommendation. Meanwhile, Exxon’s debt has declined from 118 to 108. Oh, and you made $1800/yr of free carry from the dividend – the interest.

Add it all up and you’ve made close to $50K with no risk! ($10K on the debt, near $30K on the stock, near $5K on the carry)

And you still have 24+ years to go!

The Current Math

Guess what? You can start the trade today and it still makes sense. It’s not as good as before, but the math still works.

Today, you would only be able to buy $108K of equity (instead of $118K) against the $100K of debt. The dividend yield is down to 4% so your income would only be $200/yr (it would go to $0 around $92) but it’s still positive and you get the remaining 24 years of stock appreciation for free.

If the stock only goes up 3%/yr, it would double and your $108K would become $216K.

Of course, I am not giving investment advice and you should read the original piece to better understand the risks involved. For example, there are some practical difficulties with shorting the debt.

How Does This Happen?

In efficient markets, these opportunities shouldn’t exist, right? But markets aren’t always efficient, especially in the short term. ESG pressures that pushed investors out of energy impacted the stock much more than the bonds.

We’ve also had the Fed manipulating credit artificially pushing the yield of Exxon’s debt down (and thus the price up). Thus, you’ve had artificial pressure suppressing the stock and supporting the debt.

Aren’t savvy investors supposed to be hunting for these near free lunches and arbitraging them away? In theory, yes, but there are very few institutional investors who will trade a company’s debt vs. its equity.

There just aren’t funds set up to do that. Most of the time trading debt vs. equity is considered very risky because it is hard to model the relative risk. Returns are too dependent on macro factors such as interest rates and fundamental changes typically impact the equity valuation more than the debt.

There is also the risk I mentioned in the first piece in that this trade is only all but guaranteed to work if you hold it until 2046 when the debt matures. In the interim, you are bearing market risk. No professional investor can put on a 27 year bet.

For that reason, you also wouldn’t want to put leverage behind it and not being able to lever up a good trade is no fun for your average hedge fund trader.

This trade works because it is boring and therefore few people will have the patience to do it. That’s the trick.