This situation isn’t very realistic but let’s get over that for now.
Your client has $110 million in cash but currently owes $100 million to a loan shark. The terms of the loan are:
No prepayments are allowed. No periodic interest payments are required or will be accepted.
The loan shark will demand immediate and full payment (principle + interest) at any random date in the future. If full payment cannot be made, then the client will face dire consequences no matter where he hides in the world.
The annual interest rate on the loan = Inflation_Rate + 2%.
The jobs your client qualifies for typically only pay about $100,000 a year. He has no assets other than cash.
Given all this, what investment portfolio would you recommend to this client? (I already have an answer in mind but want to see what others think.)
He should be able to get a pretty decent line of credit set up with $100 mill cash in the bank and $0 on the book liabilities to keep him safe if the loan shark comes knocking. Don’t really have anything more to add, maybe someone else can, would have to think about it more.
Basically unless you can invest in something that can yield Inflation+2% per year, you are dead in the long term. Tried to create a simple Excel estimating the time when you can still have positive equity, result is if you are only able to invest cash inflation rate & your saving rate is ~50% (good job!), you’ll be in negative equity position by the 6th year.
Can your client get into the loan-sharking business and find a greater fool who will take the same deal you took to offload the risk?
If CPI is the definition of inflation, that’s an annual hurdle of 1.5% currently. Add the 2% spread and you are at 3.5% annually. Granted, you do have a $10 million cushion to absord some of the negative real rates caused by the fed’s bond buying binge.
If loan-sharking is not an option, one approach would be to buy 10-year corporates which would just cover your 3.5% nut. You do have some interest rate risk with these but you also have a 9% margin of safety with your $10 million of additional capital. This approach would provide verly little upside to the client., with profits only occuring if rates decrease over the long-term… The real risk with this strategy is that rates increase dramatically.
Depending on their risk tolerance and confidence in their ability to invest, you could also employ a market-neutral pair trade strategy to claw back as much of the negative real interest rates as possible margined with some short-term debt.
If it were me, I would probably choose the latter of the two and start pair trading. I don’t like having my destiny tied to something I cannot control like interest rates. At least with pair trading, if I became shark bait it would be because I could not pick stocks.
Buy 100M S&P500 Index. Buy long puts to delta hedge the position. Then swap the total return from the S&P500 Index for fixed rate on 100M notional. Add language in contract for early termination.
The problem implies finding an asset or strategy with a sharpe of ~1-1.5. Chad’s got it right in that a bond index is probably the best as far as single assets go, imo.
It’s a bad proposition for the client and agree with every suggestion for finding a means to get out of it, lol. m2c.
The problem with bonds (and stocks as well) is that there is so much downside interest rate risk. You can try to get floating rate bonds, but the spreads are tiny and they are off of the front end of the curve, which is already below inflation. You can go to lower quality or high yield, but those spreads are likely to blow out if there is an equity shock, which is precisely what will happen if interest rates rise, despite the fact that the bonds are floating rate.
So, really, if you have a short time horizon and need to get 2% and aren’t willing to take any risk, you don’t have options. If you have a long time horizon, and want low risk, you’re still kinda stuck, although you can hope for better valuations down the line.
Probably the best strategy is to sell deep out of the money calls, but to get to the 2%+inflation hurdle, you may not be able to go that far out of the money. The VIX is relatively low and another government shudown and possible taper are in the near-term future, not to mention Iran and Syria, so you might try long straddles and strangles, but of course whether you actually make money on those depends on whether implied volatility is high enough or not.
I’m glad you posted the question, because it forces us to think a little, and is way more interesting than most of the stuff going on in Water Cooler.
I would not take meaningful risks until there was a danger of falling below the amount owed. For the first few years, I would invest in mostly short term, or inflation protected fixed income with some higher yielding corporates mixed in to try to do a little bit better than inflation rate without taking too much risk. It’s also possible that in five years, real interest rates would become favorabe. If so, I would take advantage and continue to invest conservatively. If after a few years, my account was in danger of falling below my loan balance, and real interst rates were still low, i would structure some kind of bet for all of money with 80% chance of winning and 25% gain if successful. If I win, I’ve just bought myself another 12.5 years. Repeat every 12.5 years as necessary.
Then, I have 100% chance of making it if called within first 5 years, 80% chance of making it if called between year 6 and year 17, 64% chance of making if called between year 18 and year 30. [Of course the 2% above inflation compounds over time but I would expect to earn more than inflation on average so I’m just assuming the two effects cancel out.]
Also, I would not worry about saving any money and would likely allocate a couple of million upfront to supplement spending money and/or quit my job.
This. TIPS still have duration and could see substantial price pressure similar to medium term Tresuries. If you sell multiple SPY call options within a 3 month time frame at across various strikes around 5% out of the money (right now) you can meet the income requirements. If the market rises then it is important to quickly roll them up and out. SPY options are European and settled in cash, so you would be able to do this. There are other variations you could do.
Although, honestly, if you talked to a structured product person, with $110mm you could make 2% with limited downside happen. Assuming you could only afford to lose ~9% (loan is $100mm) you could probably just have them set it up with that exact structure.