Last week, I wrote about one of the worst possible risk-reward decisions. This week, I will make my case for one of the best.
Now, before we start, some disclosures. I may own some of the stocks I talk about. You shouldn’t take what follows as a recommendation to buy those stocks. They are only examples of a trade idea that can apply to many stocks in today’s market. You should screen for your own stocks that fit the concept rather than rely on me.
Additionally, this trade may only be able to be executed by professional investors and, even then, with difficulty. I have not done it myself yet for reasons I will explain below (hint: shorting debt isn’t simple).
The purpose of this entry is to show how dislocated financial markets are today. This trade should not exist. It is emblematic of the blind spots professional investors have as they overlook high return, low risk trades because they a) “aren’t working” in the current market, b) don’t fit a traditional institutional investment framework, c) have near term mark to market risk and d) require patience as profit is possible in the short term but only guaranteed over the long run.
The Idea: Low Risk Carry
A carry trade is simply a form of risk arbitrage where you are long a financial instrument that has a higher expected return than the one you are short.
A common carry trade is in the f/x markets where investors will buy higher yielding currencies and short lower yield ones. Note, theoretically, there is no expected profit here. Interest rate parity theory suggests the lower yielding currency should appreciate to offset the interest rate differential.
However, in practice, currencies can violate parity for a long time. The most well known currency trade is the yen carry where investors buy dollars and short the yen. For long periods of time, the yen has failed to appreciate and even depreciated. Thus, investors made money on the yield differential and on the $ appreciation. That’s right, you were being paid to buy the currency that was expected to go up! However, this is obviously far from a risk-free trade. There are periods where the yen strengthens and traders get decimated.
Another well-known carry trade was popularized by the hedge fund LTCM. They observed an anomaly in the Treasury market where older Treasuries (called “off the run”) had higher yields than similar maturity new issue (“on the run”) Treasuries. Simple math suggested over time that the cash flows would be the same and thus it was better to buy the off the run bonds. This was absolutely right…as long as you had absolute certainty you could hold to maturity. LTCM didn’t. They had used leverage and were thus susceptible to a run on the bank if positions temporarily moved against them…which is exactly what happened.
A Safer Carry Trade
But First A Warning…
I tell you all this because you should be forewarned: there is no such thing as a riskless carry trade. However, you can get awfully close to one at times. As mentioned, if LTCM didn’t lever up and just held a smaller position size, they could have ridden the volatility out through maturity. Even if you size your position appropriately, there are still risks in the trade I will outline and I will describe all those risks below. My view is the risks are small relative to the outsized reward potential.
Buy XOM stock + Short 2046 Exxon debt
= 2% carry on notional and free 27 year stock call option
OK, enough disclaimers, let’s get on with the show. ExxonMobil is one of the safest credits in America (still AAA at Moody’s and AA+ = same as the government as S&P). It issued 30 year debt in 2016 with a 4.11% coupon. That debt now trades at 118! That gives it a market yield of 3.08%.
I want to short this debt. Why? Because Exxon’s stock pays a dividend that currently equates to a 5.0% yield. That’s right I can get paid almost 2%/yr to long Exxon’s stock and short it’s debt. But wait, there’s more! I also get all the appreciation in Exxon’s stock price over the next 27 years! But wait, is there even more? Why, yes there is! If Exxon can raise its dividend over time, the positive carry gets even larger!
How Much $ Can I Make?
Assume I buy $118,363 of Exxon stock and short a similar amount of the debt (this is $100,000 of par debt to make the rest of the math simpler). My annual dividend is $5,918 and my interest payment is $4,114 (the coupon * $100K). I am making $1800/yr. If I can invest that at 5%, it produces almost exactly $100K in year 27 when the debt comes due.
Additionally, I only have to repay the debt when it matures at par. Thus, I make $18K from shorting it above par. Now, we are at $118K of future profit (practically the same as our initial investment by coincidence). And I still have the Exxon stock! If it appreciates 2.6%/yr, the stock will double over 27 years. If it appreciates 5.25%/yr, the stock quadruples to $471K. (Note, while these may seem like low rates of appreciation, combined with the dividend yield, it’s a 7.5-10% total return.)
There is also further gain from the dividend increasing over time but the math becomes harder at that point, so I stopped to save time. Let’s go back to the scenario where I make $118K from the dividend carry and another $118K from the stock appreciating 2.5%/yr. While this is arguably conservative math, it produces a triple vs. the original principal.
However, it takes 27 years to pull off. Thus, you are earning essentially a 4% annual return which maybe doesn’t sound too exciting…until you remember it cost you nothing! Your short paid for your long so you got $360K of future value for free! Why not make this bet 10X bigger and make $3.6M?!? Well, if you can comfortably do that without taking on leverage, perhaps you should. There is no practical limit to sizing this aside from your risk tolerance and marginable assets, which is why I will now get into the risks.
What Can Go Wrong?
So I talked earlier about what can go wrong with carry trades, namely they’re either not as guaranteed as they seem or you may not be able to hold the trade until maturity. Let’s review these issues.
It would seem we have a fairly tight fundamental hedge. We have one of the most creditworthy companies in the world which would suggest the dividend is pretty darned safe. If something catastrophic did happen and the stock went to 0, the debt would lose most or all of its value.
If something bad happened that caused Exxon to eliminate the dividend, it would likely mean the perception of the debt changed and Exxon would see its credit downgraded which would cause the debt price to fall with the stock. Frankly, even in this scenario, you still only need the stock price to grow > 3%/yr long term without a dividend to beat the debt cost. That’s a fairly low bar.
The only real way to lose on the pure carry part of the trade would be if Exxon cuts the dividend in a way that doesn’t harm the credit. This isn’t out of the realm of possibility. A world of lower oil prices or substitution of renewables for fossil fuels could reduce cash flow and cut the dividend. In most cases, this would also harm the debt, but not always. Still, the dividend would have to be cut by half or more to be behind the cost of funding the debt. The other obvious way to lose is if the stock had negative returns over a 27 year period. Possible, but very remote. Then again, Exxon stock has been flat for over ten years now.
The more likely way to lose is if you can’t hold the trade until maturity. In the three years since issue, the debt has appreciated 18% while the stock is down double digits. That is an unpleasant outcome, even if you know it corrects in the long run. So, the first safeguard against market volatility is to only put on a position that has no risk of a margin call. In other words, if the position got marked 50% or even 100% against you, do you have enough other assets to cover the margin requirements? This allows you to ignore the volatility and continue to hold until maturity.
The other risk is whether you can guarantee the short in the debt or not. This is the main reason I haven’t pursued this trade with real money yet. It can be hard to short debt as a retail investor. Even as a professional, there are perils. Namely, you can’t guarantee that the owner of the debt won’t call it away from you.
Thus, the greatest risk in the trade is that you will be losing money in the near term and the debt holder will decide they no longer want to let you borrow their stock. This forces you to close out the trade at a loss. If you can’t find a way to guarantee availability of borrow until 2046, you can’t be certain you can hold the position until maturity.
If anyone has suggestions for how to ensure borrow for that long, please reach out to me! The only idea I have is a synthetic structure where you short Treasuries and the Exxon CDS to replicate the Exxon debt, as it is much easier to maintain a Treasury short. While this may hard for someone to do at home, professional investors should have the ability to execute this trade. Yet, they haven’t.
Why Does This Opportunity Exist?
Because financial markets today are really, really messed up. It’s worse than that, but that’s the only PG way I can say it. There are certainly some legitimate hurdles, like the mechanics of shorting the debt. There are also practical hurdles such as most investors not having long investment horizons. However, the ability to get 2% for “free” attached to a free long term call option on Exxon stock is a pretty rare opportunity that shouldn’t exist.
As I mentioned in the beginning, I am not giving stock advice to buy Exxon. This spread exists at many other companies. Go look for stocks you want to buy and compare their dividend to their long term debt. In insurance land, PRU is >1% carry and PFG is around 1%. This is not about energy being out of favor. I also don’t have any specific insights to suggest why Exxon is at 2% rather than 1%. I used it because it best illustrates the point. One of the best known companies in the world has this giant positive carry between its stock and debt and nobody seems to care! That is a really, really messed up market.
Frankly, you could spend some of that 2% spread on interest rate hedges if you like, as the decline in market interest rates is the main reason the bonds have appreciated so much. You could even spend some to hedge oil prices if you like to protect against a decline in Exxon’s stock or buy some put options. You would still have enough left over to get a 27 year call option on Exxon stock for free. This shouldn’t be possible!
1) Markets are messed up.
2) There are some very attractive low risk trades available as a result.
3) Just be aware of all the risks before you call your broker.