In the last post, I stepped you through a couple of fairly basic strategies for hedging your portfolio against the risk of discrete corporate bankruptcy. While posing a significant financial risk to your investment, corporate bankruptcy is generally considered to be a fairly minor risk due to the breadth of options available for an individual to diversify out of the risk. However, what happens when we magnify the scale of bankruptcy risk to the point at which it pertains to a municipality, state, or even a country?
Suppose a city issues a bond for a bridge that collapses? What about a state that suffers from a massive oil-leak, and needs to raise more capital to rebuild the pipeline? What about countries like Iceland, that become the victims of great economic circumstances due to their smaller size? Especially given the volatile political climate of the EU in today’s market, how is it that we can protect ourselves against the risk of insolvency from such a colossal entity? (**note: Interestingly enough, Jefferson County has filed for bankruptcy during the editing of this article, so I’ve fixed things up to be a bit more relevant**)
When dealing with bond risk, institutional investors use products called Credit Default Swaps to protect against the risk of default. These assets provide a very valuable measure of insurance against an insolvency event dealing with the underlying country, and therefore also protect the downside risk of your investment. Unfortunately, they are not particularly accessible to smaller investors such as ourselves. Granted, it is sometimes possible for a smaller investor to buy CDS contracts from a larger bank’s own inventory (because the bank itself is hedging its own positions by the millions), we generally need to find other mechanisms for protection.
In the search for certainty, I would again draw our attention towards the different types of municipal/state bonds, and their relative risks. Safest of all these bonds is the general obligation. They are not just backed by the good-name of the governing body, but also by its powers of taxation. What this essentially means is that, in the event of insolvency, the municipality must increase taxes on the local population, and use the proceeds to continue paying off the obligation you purchased. This makes for an extremely safe purchase, especially when you buy it in conjunction with a powerful bank like JPMorgan, which has the capacity to force a municipality to implement this measure. Next in the line are Revenue bonds.
These bonds are dependent on specific fees or incomes. So if nobody is using the government parking-lot, you don’t make any income from the parking-lot bond. Governments are under no obligation to repay these debts. Looking at recent history, it’s pretty easy to realize that we should be owning general obligations in this poor economic environment. However, the event of default is an interesting one for these securities. In most cases, governments don’t so much default as they do suspend payments for a period of time.
This means that your principle is generally safe, even though you’re making a loss against other opportunities. Additionally, yields will increase significantly during this period, even though USA municipal/state bonds have a high tendency to recover after a default. The end result in many occasions is the emergency of a great buying opportunity. Even though we may have been burned, it’s possible that we can make up the difference in the mid-term on the yield-correction alone.
Lastly, we can always turn out attention to the world of mutual funds and ETFs. Specifically, look for specialized bond funds that bear the full risk of whatever asset it is that you’re concerned about. Perhaps a bond fund that specializes in US treasuries can be used, or an EU fund, or even a municipal fund. Whether they take short or long positions against these assets, we can look to them as being a back-bone to our position as we look to diversify out of short-term insolvency risks.
For example, if we hold a portfolio that contains rapidly sinking Greek bonds, we can purchase an offsetting position in an inverse bond ETF that has a similar exposure. Some simple weighted average math calculations (that’s what your advisor is for of course) can give you the exact number of units needed to diversify your risk to the point at which you have neutralized your Greek risk, but still retained your other upside exposure. Better yet, the scale-value of an ETF allows you to engage in this transaction in the most cost-effective manner possible.
In comparing the options available to a personal investor when dealing with corporate securities and government, it becomes apparent that one of these markets is reasonably more accessible than the other. This is mainly because the amount of money raised in government bond auctions are much greater than that in corporate bonds, and these investments are generally targeted more towards financial institutions.
However, it is important to always remember that we still have access to these positions, and that we have a reasonable ability to diversify ourselves out of the greater, seemingly non-systematic risks, associated with them. Now that we’ve discussed the basics, I’m going to dive into some of the more exciting instances of bankruptcy in my next article. Specifically, I’m going to describe a situation in which your entire portfolio could evaporate overnight, even though the equities still retain the same full value that they had the day before.
