Attempting to prevent financial disasters is too costly

What does it mean to prevent financial meltdowns?  Suppose you could buy an insurance policy against a financial catastrophe.

Let's keep this very simple, for a concrete example.  Suppose you want to buy a binary security linked to GDP for one year.  Such a security pays the holder $1 if U.S. GDP drops by 10% or more in a calendar year, zero otherwise.  That's what we'll define as a financial meltdown.  The price of this security is the insurance premium for one year of financial disaster protection.

Suppose a household needs $1 million of this security to hedge their exposure to the risk.  This $1 million payoff presumably must cover (the net present value of) losses to financial assets, employment income, real estate, etc. if such an event occurs.

In addition, the buyer of the insurance must be confident that the provider of this protection will be able to pay off the $1 million if the event happens.  That's a serious concern.

"Bonds Now!"...Not!...Part 1 of (probably) very many...

Driving to buy New Year's champagne this afternoon, I heard on "The Hayes Advantage" and interview with Marylin Cohen of Envision Capital Management. Shockingly, she's on the radio with a new book out called "Bond's Now".

Here's the thing: Bonds, by construction (with some exceptions) should be considered duration risk plus a put on equity in something. So, for example, any bond return may be decomposed into "riskless" duration (that trades off the highly liquid and extremely efficient U.S. Treasury market) and a spread above that rate that reflects the chance the company (or entity) won't pay back the principal. That spread looks very much like a put premia: The holder of the bond receives it when things are good. When things go bad the investor doesn't earn the coupon. When things go really bad the investor doesn't get the principal back. This is reasonably basic stuff.

Let's hit a couple of assumptions: Yield from duration is riskless. Yes, assumption here is that nominally, duration risk calculated off US Treasurys is riskless on a buy and hold basis, especially for the domestic US investor. Clearly this is not the case for real returns (net of inflation.) Nor is it true for other than held to maturity bonds. This yield (and return to duration, if the bonds are traded) passes through by definition to the corporate bonds.

Second, let me address "a put on something" very broadly. You buy debt in public company XYZ that is highly liquid. If the equity goes to zero, then there is no "protection" for the debt, and it starts to erode. What about asset based loans, or debt to private dompanies? More or less the same, it is just that the equity is not publicly traded. You are selling puts on private equity.

What about muni bonds? Let's leave that for later.

So, let's assume an investor knows they are taking these risks. (Big assumption here. I don't think many people seriously consider this.) You want to take duration risk and write puts on diversified equity. (Investor is buying corporate credit index, for example.) Which makes more sense? Option A: Buy duration in a moderately liquid corporate market, and combine that with selling puts in a moderately liquid market only on the selection of companies that happens to need to raise cash, and does so via the debt market instead of the equity market. Or, option B: Buy duration in the single most efficient market in the world using your choice of instruments, and sell puts on broad baskets of all companies?

Generally speaking, option B sounds better to me. That certainly reflects my bias toward wanting to trade in the most efficient markets, (unless I think I have an edge,...which is rare...and I usually talk myself out of it.)

Many more thoughts on in the new year...enough for now.