It’s a funny thing, isn’t it…?
While all the world is crying that the lights are going out, and the skeletons and ghouls of every blood type and flesh tone are howling over some reddish moon Tuesday or a Shanghai Monday, shrieking that the market is crashing and the ocean floor has been torn asunder, we here at Normandy just have a giggle and look at this –
And we say, “what the fork?”
See for yourself, friends. The most sensitive investment instrument on the planet hasn’t budged a whit! Credit Default Swaps (CDSs) on the largest American financial institutions show that there’s absolutely no sign of panic among insurers at a time when the financial media would have you believe that we’re in the midst of a redux of the Battle of Kalka River.
CDSs, for those who require a reminder, are insurance policies, so to speak, against non-payment of debt. And the price of that insurance rises or falls according to how much trouble the market perceives, say, Bank of America may have in servicing its debt obligations.
Because banks are essentially debt issuing businesses, their CDSs are extraordinarily sensitive to changes in the broader financial and economic prospect – as the example of the crash of 2008-09 shows. Then, the price of insuring bank and broker debt went positively lunar (see blue spike on charts above).
So what gives today?
At this stage, again, the market hasn’t blinked. There’s no sign that creditors are anxious in the least over the latest market swoon – at least insofar as it may impact on the obligations of banks and brokers to repay their debts.
And that’s meaningful in the extreme. Because those who underwrite and sell these policies are acutely sensitive to both overall market conditions and the potential to profit from them. That is, if there was a market to push the cost of Wells Fargo CDSs significantly higher, they would, indeed, be significantly higher. Moreover, because the CDS market is plum-filled with speculators, the fact that prices haven’t jumped further
proves the point that ultimately this is a market decline filled with sound and fury, signifying nothing.
Perceived Instability and How to Profit Therefrom
We’re going to offer you a trade to capitalize on this – we believe – very important contradiction, but first we want to walk through an open trade that may require your attention.
Just a week ago, we launched a complex trade on Goldman Sachs that involved selling a near-term ‘straddle’ and using the proceeds to buy a longer term ‘strangle’. The goal was to collect our straddle premium, watch it expire near worthless and then let the strangle pull in bigger winnings as Goldman began moving strongly either up or down.
So far so good. Since last week, GS stock has barely budged, and with just a day left before the 180 straddle expires, shares are trading for 185.68 and S&P futures are indicating a flat open on the day (our breakeven for the straddle is $185.90).
Our best advice is that you just leave everything be and watch your best friend – time – eat away at the straddle’s value. We would add, though, that if you happen to see GS pull back to 180, we would urge you buy back both sides of the 180 straddle immediately, as that would be the cheapest possible outcome for the short side of our spread. Leave the long strangle open come what may, of course, to catch any big move in GS over the next five weeks.
Now back to our trade for the week…
This week we’re going to recommend a trade that’s not options related, though it is leveraged, and it’s one we like particularly well when markets are swooning and the panic is on.
It’s a trade that employs a vehicle known as a Closed End Fund (CEF), a mutual fund in essence, but one that trades on a stock exchange rather than via an individual fund company.
And because it trades on an exchange, it almost never trades at par with its net asset value (NAV), as a regular mutual fund does. Most of the time it trades at a slight discount to NAV, though some more popular issues will at times trade for lengthy periods at a premium.
Falling Markets Compel Deep Discounts
In the last three weeks, along with the dive in the indexes, CEFs have been driven lower in extreme fashion, the majority have seen their discounts widen appreciably, and some sectors have been shamelessly forced to the wall.
That includes the above discussed financials, but perhaps more than any other sector, high yield bonds – a subset of the financial group – have been hardest hit.
We’re going to look today at a single CEF that trades in the high yield sector and that we believe constitutes great value at this stage for two reasons –
1. It’s dividend has gotten bloated way beyond proportion, and
2. The opportunity for a great snap-back gain is in the offing once the sector recovers, the stock rises and the discount to NAV begins to close to
The stock is called the Blackrock Corporate High Yield Fund (NYSE:HYT), it trades for $10.11, while its holdings are worth a fat $12.05 as of last night’s close. That’s a 16% discount on a CEF that historically trades just 4.5% below par.
Have a look here –
A glance at the chart shows a stock that traded in line with its NAV for two and a half of the last five years, until high yield began falling out of favor in early 2013. But the latest retreat from the stock’s NAV marks an extreme level even for the last quarter decade. And we feel a bounce is in order.
At these levels, HYT pays an 8.3% dividend – compared to ETF HYG’s 5.3% – and offers a better chance for a spring higher in a general market rebound.
Options Trader Elite (uncharacteristically!) recommends you consider the purchase of HYT shares as low as $9.95 with a stop loss placed at $9.45.
With love of the hunt,
Hugh L. O’Haynew