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It sounds like a can’t miss offer an investor might find coming from the mouth of an unregistered pitchman touting questionable investments: “Income without rate risk,” is part of a headline in a new option report. But Goldman Sachs options research team of John Marshall, Katherine Fogertey, Vishal Vivek and Arun Prakash think they can deliver bond-like income without rate risk. Spoiler alert: it involves derivatives, a short volatility put strategy and no bonds.

Invest 15% of portfolio exposure in 100 “secure business model” stocks, Goldman recommends

When looking to develop their “Bond Buyers Equity Basket,” Goldman Sachs options researchers don’t much care for the concept of “bond buyers” actually buying bonds in a July 5 report. The basket is entirely made up of stocks along with an income generating synthetic exposure method.

The investment recommendation is “designed to give investors high current income with an added layer of downside protection,” the report noted, pointing to 5.5% returns year to date, “outperforming the Investment Grade bonds (iBoxx IG Index) by 1.2%, with lower volatility” and no bonds in the portfolio.

The strategy has two asset components that, like many short volatility returns profiles, skews heavily towards the income producing asset. This includes a stock basket, with a 15% exposure, and a “fully-collateralized put-selling portfolio” that serves the point of “cash flow” generator.

The stock portfolio includes 100 individual names that feature “strong unlevered free cash flow, strong balance sheets, and secure business models.” While unlevered free cash flow and strong balance sheets are quantifiable measures to various degrees, the “secure business model” analysis might be more discretionary in nature.

Those stocks with a “secure business model” might not give much weighting to the concept of Amazon taking over the free world and the Internet revolutionizing the cable industry and paper communications. The list of secure business models includes Michael Kors, Ralph Lauren, Comcast, Time Warner, Walgreens Boots, CVS Health, Wall Mart, Verizon, CitiGroup, Bank of America (but not Goldman Sachs) and International Paper.

Don’t sell covered call options to enhance portfolio income, sell puts, Goldman recommends

The second component of the “bond buyers” investment mix involves an option strategy that is correlated to the stock. The conservative version of this strategy is to sell a call against the long stock market exposure, known as a “covered call.” The profit in the stock is limited to the extent of the strike price of the call, with loss risk only occurring if the stock falls in price below the amount of the premium collected on the short call option.

Goldman Sachs, however, has a different take on the traditional buy-write option strategy.

Instead of selling calls, they sell puts to juice the premium collected.

The idea is to sell puts on each and every stock in the basket. The put seller collects as payment the premium for selling the stock option, which is the limit of the profitability of the option portion of the trade. But the lost on the naked short put option is the amount the stock price might fall beyond the strike price sold less the option premium collected.

Under a stock market crash scenario, both the long stock market exposure and the short put exposure would lose money at the same time. This method of using derivatives in combination with stocks to create a highly correlated event to the downside – both the stock and short option exposure lose money – has been humorously called a “Texas hedge” for its lack of hedging.

“The put selling portion of the portfolio reduces overall risk and increases overall yield despite lowering average returns over the period,” Goldman Sachs says. “Each put we sell is designed to collect the un-levered free cash flow yield expected in that stock. In years when our expectations for uFCF-Yld are low, the puts sold target smaller yields and as a consequence are far out-of-the-money. This reduces risk in the portfolio. In the put-selling portfolio, investors profit as long as stocks do not decline more than the strike price (12.0% out of the money) plus the put yield (2.8%).” There was no modeling available regarding what happens if all stocks trade below the short option strike price.

Beware of bond-like investments that claim “income without rate risk.” There is always risk, it’s just a matter of where it is located.

Insight / Analysis / Opinion: 

Buying stocks and selling puts is typically considered a one directional strategy that has catastrophic failure risk associated with it, particularly when the puts are sold “naked” without any corresponding purchase at a different put strike price.