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Are there any distressed bond investors out there in cyberspace that actively hedge their positions using equity put options?

I'm wondering about the best option. If you buy an in the money long dated put, the cost is high. However, an in the money put is essentially a synthetic short, and it should move pretty much lockstep with equity. Its gains should mirror equity's crash in the event of bankruptcy. The downside is that the hedge is so expensive that it eats up the bond's yield.

On the other hand, one year out of the money puts are cheaper. They're movements are less predictable, though. Is there a rule of thumb on constructing a hedge; is it better to look in the money or out of the money?

Peter
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Are there any distressed bond investors... that actively hedge their positions using equity put options?

Peter,

I experimented with this technique last year, and I decided it wasn't worth the difficulties, the costs, the uncertainties. I used OTM LEAPS. Also, I simply went short the common of the issuer whose debt I owned. I broke even on my options (or a tad to the good) and made some decent money on the shorts. The hassle with trying to protect questionable positions is that you shouldn't be in them in the first place. You're just throwing good money after bad.

Step back and think about 'investing'. Not just bonds, but all of investing. You know from the get-go that you're going to suffer losses. That's both unavoidable and no biggie. Losses are merely a cost of doing business. So the question to be answered is "What's the most effective way to manage them?" Per Taleb, two possibilities suggest themselves: 'robustness' and 'anti-fragility'. Most investors think in terms of trying to buy "insurance". But the better strategy (or tactic) isn't a hedge that salvages most of one's value (think fire insurance on a house), but a strategy/tactic that pays off at multiples of one's losses.

No matter which asset-classes they own, what should have most investors not just worried, but terrified? Central bank stupidity, right? That's the threat to focus on, not individual investments. (IMO, 'natch) In short, be prepared to get massively short when the time comes to get short, and laugh all the way to the bank (if such things still exist). But as long as they don't close markets (or re-institute 'no-shorting' rules), any investor can not just protect assets, but increase them.

Charlie
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Charlie,

I've been thinking about Sears Holdings long dated bonds, which are yielding 10% while trading around 70, accordign to FINRA. Shorting 5 $20 puts 1 year out is just under $400. If Sears utterly bombs out, the puts are worth about $10K, recovering capital. If Sears is fine, you lose the put and walk away with 6% yield on the bonds.

The negative is that you need to roll the puts in order to maintain the hedge, and they could be more expensive in a year's time... Then you're left with an unhedged brick and mortar bond position in a dinosaur. Then again, if they're more expensive, then its likely that material results at Sears have improved and you have less need for the hedge.

Have you looked at Sears at all? The situation looks bleak, but Lambert has a big bet on...

If equity has any value at all, the bonds should end up being okay and that yield is tough to match in this market. Any potential here from your point of view?

Peter
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Peter,

The sorts of numbers you ran for Sears is exactly why I backed away from using options to hedge bonds. The gains are too tiny to bother with. 6%? I've got bond positions on right now in which I'm up over 100%. Big whoop if I lose a couple. My net still beats the grief and small returns of a hedged bond strategy.

Also, I'm not worried about a market crash. The bigger and nastier, the better, because it will clarify things. (But I would like it to hold off for another two weeks while I'm a fishing trip. LOL)

Yeah, I'm long some of Sears debt, just as I'm long some of just about every issuer in the market. That's what a bond investor does. He buys bonds. In fact, he buys a basket of them, and that basket, through its composition, is his "hedge". OTOH, if a person were to buy selected distressed issuers and then hedge them, then he/she could eke out the protected gains you're describing. But that's a different game. A viable game, but a different game, and not the one I'm playing.

If you see a clear path, go for it. (I've got other fish to fry, quite literally).

Charlie
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