Saturday, April 22, 2006

Convertables or cash?

At this point, the full effects of $75 oil and higher real interest rates are very unclear. But we can predict with confidence that they will be negative to overpriced stocks. One sign of this has been a weakening of the spread between treasuries and junk/BBB bonds. It seems like the market in general is forgetting the importance of certainty in uncertain times. For people with investments in the broad US market, for example S&P 500 shares or similar broad market mutual funds, now is good time to shift to defensive assets to protect your capital and therefore have it around when new opportunities emerge. Seth Klarman also has also noted this, in his January 26, 2006 letter to investors:

The world could well be setting up for considerable upheaval and with it an avalanche of opportunity. As we have said, nearly every investment professional is fully invested, and many are leveraged. With massive trade imbalances and huge U.S. government budget deficits, tremendous leverage everywhere you look, massive and unanalyzable exposures to untested products like credit derivatives, still low interest rates, rising inflation, a housing bubble that is starting to burst, and record and unprecedentedly low quality junk bond issuance, there appears to be little, if any, margin of safety in the global financial system. The day of financial reckoning for these and other excesses has been repeatedly put off, creating the illusion that risks are low, when in fact they are enormous and rising. High energy prices, ongoing terrorist threats, and nuclear proliferation add to the vulnerabilities. While we won’t hesitate to take advantage of investment bargains we uncover at any time, we are preparing our team to be well-positioned for the emergence of an expanded opportunity set.

There are many possible defensive investments that you can chose from to reduce your exposure to the broad market. I think it's very reasonable to shift up to 50% of your investments in S&P 500 linked assets to uncorrelated assets with less US market risk. Two good choices in my opinion are risk-free high yield savings accounts, convertible securities funds. If someone had $20,000 in shares of SPY, I think it would be quite reasonable to switch about $10,000 of that into a combination of a money market account and convertable securities fund. Based on modern portfolio theory we can create any desired risk profile via a combination of a risk free asset and one or more risky assets. By combining a risk free asset (the savings account), with a less risky asset (the convertible bond fund), and a risky asset (the broad market fund), we can create portfolio with less total risk. And that is a good thing.

Right now FDIC insured high yeild savings accounts are offering up 4.60% on deposits. At moment VirtualBank eMoney Market is offering best deal @ 4.60% APR on their eMoney Market Account. Other banks like HSBCdirect, Capital One, and Emmigrant direct are offering 4.50% or 4.25% on online savings accounts.

Convertible bonds are the thing with feathers; to paraphrase Emily Dickinson. They participate in the upward price movements of the obligor's stock, and yet they cannot bury themselves below the ground of their intrinsic bond value. And while their value fluctuates above a floor value, the bonds are paying interest. This risk return profile, is caused by the call option value of the bond's conversion feature. Convertible bond funds are a good way to reduce portfolio risk while still participating in the market. The non linear nature of convertible bonds suggests that active management is useful so long as it is not too expensive. The Vanguard Convertible Securities Fund, (VCVSX) ($10,000 Min) or Fidelity Convertible Securities Fund (FCVSX) (2500 Min) are good choices.


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