A Comment -- General Comments From an Expert (A Commentary)

Does buying a one-year to expiry $500 Call and a $480 Put make a “no man’s land” zone between $500 and $480? This is basically a Straddle. The problem with this strategy is that you are putting it on for 1 year so you have a huge amount of time value in those options. You really have to have a lot of volatility to make money because you have to make money on the combined price of the Call and the Put. Options are a wasting asset and you could really get wasted.

Would it be a good tactic to invest directly in the indexes or ETFs? For the smaller investor he recommends that they buy the Canadian and US index rather than ETFs. All the banks have a Canadian index and some of them have a US index fund. The cost is about 75-85 basis points and there is no commission. If you’re putting money in on a monthly basis, you don’t get dinged for transaction costs. For other investors, there are just not enough indexes in Canada and he would recommend ETFs.

Short-term bond ETF? He normally has the iShares DEX Short Term Bond (XSB-T) but lately has been using Horizons Floating Rate Bond (HFR-T) which has pretty well been rock solid and didn’t get affected when it looked like the tapering was coming into play. (See Top Picks.)

Should the Strike Price for selling a Covered Call be a certain percent over the market price or be where most of the open interest is? This really gets down to what you want to do and what your objective is in doing the trade. He likes to Sell as close to the money as possible, 6 months out, because this gives him a better return by selling them at the money.

As an option becomes deeper in the money, it’s time value tends to decrease. Why? Option traders want leverage. If it’s a $50 stock, they are willing to pay $2.50 for that option for it to go up $4-$5. If it goes up $2, the price until $55, will suddenly be the intrinsic value of $2.50, but the time value will actually only be about $1.25. This means that as the option increases in intrinsic value (i.e. above the strike price), the time value is compressed because they don’t want to pay for that much leverage.

Markets. He is comfortable in the Natural Gas space. Cost has doubled in the last couple of weeks. See a range between 1100 and 1300 for gold. Thinks Nat Gas will come off a little when temperatures go up. Inventories were normal and US production leveled off. Sees strong demand trends. Inventories coming out of this year’s winter could be at 5 year lows. Nat Gas is a North American phenomenon. For Base metals it is about emerging markets.

Markets. Investors may be in danger of chasing US’s last year returns. Last year was such a great year, particularly for those outside of Canada. He expects what we are seeing now is just a slowing down of expectations. We are only seeing 1.5%-2% growth in the US, so why would you pile money into the US. The catalysts for the US are there, but this is not going to be a 3%-4% or 5% type of environment for growth. Expectations in the US for many sectors are well, well ahead of themselves. He would say the same for Europe. Thinks the defensive, slow-growing opportunities in the developed economies definitely have developing opportunities, especially in Europe where companies have exposure to international/emerging markets.

Asia. He is staying away from Japan because he thinks it is a financial engineering play. However, he is starting to look quite closely in Asia because there are a few countries with really good balance sheets and currencies are obviously being pushed down. When the blood stops, he’ll definitely be looking to take advantage.

Do you find any value in the trend of country-specific ETFs like NORW or ENOR? Generally, he is not an ETF person. If you like Norway, go find some good Norwegian companies. On ETFs, you want to find a market that has good fiscal fundamentals, which Norway does have. You want to find a market where it has companies where you like the growth prospects of the top portion of the ETF. You also go to one that is relatively liquid that you can trade in and out of.

Economy. Expects the US Fed will be announcing another $10 billion a month of tapering. This is Bernanke’s last meeting so doesn’t expect he will change anything. US deficit is shrinking faster than the tapering will take place, so it won’t have a material impact on the supply/demand on the bond market. The S&P earnings yield minus the 10 year treasury yield has narrowed 5% a year to 3%, which suggests that bond yields are still too low so perhaps the equity market has room to go higher. This means that it is a borrower’s market, not a lender’s market. His Real Yield chart shows that bonds are expensive. Real Yield since 1920 has averaged 2% on government bonds but has gotten to negative several times since 2008. Now it is above zero and we are at about 1%, but really should be 2%. It will gravitate towards that as these anomalies come out of the marketplace. He is bearish on the bond market but thinks yields will rise that will cause some pain for long-term bondholders. He’s in the camp that suggests you Buy 3, 4 and 5 year investment grade corporates and roll down the yield curve. The yield curve is very steep, say 20 basis points a year, so if you buy a five-year bond today at 3%, a year from now it is going to be 280 and if nothing changes, the year after that it will be 260. This means you are gaining price momentum off the bond as it gets closer to maturity, so you are getting less downside risk in the price and you get positive return. The Capital Gains days are over for “real yield bonds” and you’ll probably earn 5% this year, which is not bad. This is the time to be buying high quality securities.

“"Rolling down the curve”. A critical investment strategy. This assures investors of 2 things. Getting the principle back safe and sound in a relatively short period of time and getting a positive return, albeit probably small, but still positive. Risks of buying long-term low-quality bonds are very high in his opinion. It only takes a small uptick in long-term yields to wipe out any perceived yield advantage.

Many bond picks cannot be purchased through my online broker. Are there other options for purchasing bonds from a retail investor? All of the major investor dealers maintain extensive inventories of bonds. They don’t make them all available to their retail divisions and online brokers because many of them are giant blocks of bonds which are sold to institutions. Talk to the help desk and see if they will look around the market for you or at least make your case a little stronger in order to buy that bond.

Future of Real Return Bonds? After outperforming everything, Real Return Bonds were the worst performing asset category in the fixed income world last year, losing over 13%. If Real Yields go to 2% at some point in time, these bonds are going down another $25 in price. If you buy these today at 1% real, you’ll get that if you hold until maturity. But at the end of the day they are long-term long-duration securities with low coupons. Very vulnerable to a rise in nominal bond yields. The breakeven inflation rate has been steady at 2%, so as nominal yields rise, the real yields rise. Would steer away from these until we have an inflationary environment.

(A Top Pick Oct 18/12. Up 2.4%.) 407 Intl. bonds. 3.87% maturing 11/24/2017. High-quality bonds. Really a utility.

On fixed income, once you pay to acquire these, your tax treatment on the income seems to wipe out most of your potential gain. Is this correct? You are 100% correct. For example, a Bank of Montréal bond would probably have to triple from here to match the after-tax dividend yield on their common shares.