BAC leverage

[racemize]

Incidentally, now that BAC-A warrants are down to 7.4% cost of leverage (includes missed dividends of 0.01 / quarter, but the rest are accounted for via adjustments), it may make sense to start thinking about them versus LEAP calls again.

 

The closest in terms of leverage appears to be BAC 2016 12s, which has a 4.77% cost of leverage; however, this cost does not take into account the future dividend increases that will be missed over the next 2+ years (only accounts for the 0.01 / quarter).  I don't think they could be high enough to pull even with the A warrants at these prices, but it is getting closer.  Given the longer date of the A's and the increases in prices of the common, I could see owning the A's again.

 

 

[ERICOPOLY]

This is something I wrote to another board member offline today, explaining why I went back into the A warrants in my RothIRA in November when the cost of leverage had come down to 7.5%.  I'm just throwing this out there because I earlier explained why it was a good time to sell them (back in March).  So to be fair, I'm sharing my reasoning why I changed my position recently.  Not that I know what I am doing -- keep in mind I am just a retail investor amateur! So I could easily be completely wrong.

 

Plus I am also going back into the warrants for their other obvious advantage -- interest rate lockup.

 

This is in my RothIRA account where I can't do portfolio margin.  There is either call options, or there are warrants.  Nothing else is available to me.

 

So I use the dividend expectations of mine when I calculate what the true cost of leverage of the call options strategy would be.

 

Sure... there is little premium to deep-in-the-money calls.  But there is a big cost in terms of the missed dividend if I choose to purchase calls.

 

So I weigh the cost of leverage when going with calls (inclusive of full cost of lost dividend) to the cost of leverage of buying the warrants today.

 

The "A" warrants won that battle this time because their cost of leverage was only 7.5%.

 

7.5% was not that bad as long as it doesn't keep decaying.  We have 5 years left.  Most people will expect the dividend will be at least 60 cents in 2017, 2018, right?  And perhaps earlier.  So the cost of leverage of those years won't trend towards zero... they will trend towards the dividend expectations, in addition to the margin interest expectations, in addition to the cost of put expectations.

 

The "A" warrant doesn't look bad at all anymore -- compared to my only other way of using leverage in an IRA, which is to purchase calls.

 

There is the added benefit that if we get a crash and the stock winds up back at $12, the -annualized cost of leverage will rise once again as we get nearer to the strike (the skewness thing).  So it ironically offers some downside protection as well (remember how the common appreciated faster than the warrant over the past 9 months?).

 

 

Looked at another way... 

 

Suppose the stock is at $25 and the call premium is effectively zero (nobody wants to buy them because of the cost of the dividend loss).

 

Could BAC "A" warrant premium also fall to a similar level?

 

HELL NO!

 

It would otherwise be all too easy to just purchase the warrant and write a deep-in-the-money call option.  The person would be taking absolutely no market risk on the price of BAC common, and meanwhile would be enjoying the full benefit of the dividend strike adjustment.

 

Therefore, the warrant premium will always be supported by the dividend expectations.

 

This easy arbitrage I mentioned will ensure this.  *Guaranteed.

 

 

 

*  Of course, I jest, I jest... there are no guarantees.  Just a little colorful hyperbole.  Clearly the market doesn't always behave the way I think it should.

[ERICOPOLY]

Right...

 

A couple of days have passed and I've decided the prior post I made was not thought out well enough.  I realize now that in order for the warrant premium to be supported by an arbitrager writing calls, then that individual would need to find somebody to purchase those calls.  But it would be irrational to purchase those calls due to the cost from the dividend -- so likely such a buyer doesn't exist.

 

Oh well...

 

[gary17]

Eric

I have another question on this strategy -

let's say BAC shares hit $8 for whatever reason next year....  and so the 2016 at the money puts purchased  will now be quite valuable....  I guess if the investor is still bullish on BAC and felt the shares are even more undervalued... one would probably sell the puts and use the proceeds to buy the commons or calls...      Ok, i'm not asking what you'd do... i'm just trying to ask if that's how one would utilize the put options if the BAC shares tumbles....    (i.e., nobody really wait until 2016 to exercise the puts....)    Thanks    Gary

[ERICOPOLY]

Eric

I have another question on this strategy -

let's say BAC shares hit $8 for whatever reason next year....  and so the 2016 at the money puts purchased  will now be quite valuable....  I guess if the investor is still bullish on BAC and felt the shares are even more undervalued... one would probably sell the puts and use the proceeds to buy the commons or calls...      Ok, i'm not asking what you'd do... i'm just trying to ask if that's how one would utilize the put options if the BAC shares tumbles....    (i.e., nobody really wait until 2016 to exercise the puts....)    Thanks    Gary

 

The puts can be viewed as a proxy for holding cash.  Once the stock drops to $8, you can flip the put into a call (put/call parity).  So it costs 30 cents today to have $8 of synthetic buying power (expiring in 2016) "just in case" the opportunity arises.

 

For taxable portfolio margin account, it may be better to just purchase the common and hold onto the puts to hedge the loan used to buy the common.  This way, you don't wind up with a potentially expensive short-term capital gain on the put (if you sell the put to buy a call, you have a realized gain on the put).

[ap1234]

Ericopoly, I am an old school investor with very limited experience when it comes to options. I am still not sure how to think about the cost of leverage when deciding to buy the common stock or the TARP warrants at a particular moment in time.

 

Let's say I were to look into my crystal ball and tell you that BAC would finish 2014 between $18 and 20. Given the end result, would you be better off owning the common stock or the Class A warrants? Let's assume that there is no dividend in 2014 (the excess capital is returned to shareholders via buybacks).

 

There are obviously a lot of moving parts but in simplest terms I'm hoping through an illustration you can help explain to me under which scenarios the A warrants outperform and underperform the common stock?

[ERICOPOLY]

Ericopoly, I am an old school investor with very limited experience when it comes to options. I am still not sure how to think about the cost of leverage when deciding to buy the common stock or the TARP warrants at a particular moment in time.

 

Let's say I were to look into my crystal ball and tell you that BAC would finish 2014 between $18 and 20. Given the end result, would you be better off owning the common stock or the Class A warrants? Let's assume that there is no dividend in 2014 (the excess capital is returned to shareholders via buybacks).

 

There are obviously a lot of moving parts but in simplest terms I'm hoping through an illustration you can help explain to me under which scenarios the A warrants outperform and underperform the common stock?

 

 

The cost of leverage in the warrant will be about 7.8% if the premium decays in straight-line fashion by the end of 2014.

 

Your $18 price equates to a return on the common of 15%.

 

So you have some advantage to owning the warrant under the straight-line decay assumption.

 

However, the cost of leverage could drop to 5% (just picking a number).  There would be 4 years left on the warrant.  So 2.8% multiplied by 4 is 11.2%.  Total cost of leverage over the next year would therefore be 19%.  The hurdle rate becomes 19%, the common stock only appreciates by 15%, you wind up losing out versus the common.

 

So it's still possible that the warrant could underperform the common as it rises to $18.

 

The gain on the common is about 27.8% if it goes to $20.  You should safely outperform the common in that scenario.

 

One alternative approach is to buy the common and hedge it with a $15 strike put for $1.40.  It only costs 10% in the worst-case plus your margin borrowing rate.  IB has rates from 50 bps to 140 bps.  So, 10.5%-11.4% total cost in the best case.  Plus, you would sleep better having a higher strike price on the put ($15 vs $13.30).

 

So in short, the warrant has a projected cost range of 7.8% to 19%.  If you qualify for the lower IB margin rate, you could instead get a cost of only 10.5% (assuming short term rates remain steady).  The higher strike price is nice too.

[racemize]

Adding on to what Eric said, as a couple of models to compare to BAC warrants, we have WFC and JPM.  Presumably, BAC warrants will act like those do once it hits normalized earnings and just grows as banks generally do. 

 

JPM warrants are 1.57% without divs and 5.22% with divs at threshold.

WFC warrants are 3.1% without divs and 7.22% with divs at threshold.

 

All three are at their dividend thresholds at this point, I believe, or are at least very close. 

 

I suspect JPM is lower due to the various litigation/settlement issues, so probably BAC would end up somewhere between the WFC and JPM rates. 

 

Alternatively, BAC has a much lower div threshold, so maybe it would get a premium to both of those (I suspect not a huge one from WFC though). 

 

Should give us some idea of normalized costs of these warrants.

[ERICOPOLY]

That's interesting that JPM warrants are 5.22%.  They are currently trading in-the-money by roughly the same amount as BAC will be when BAC is trading above $18.  BAC warrant premium costs more today but today BAC is closer to strike price (and skewness has an effect on that embedded put premium).

[gary17]

Eric, Race, when you guys talk about cost of leverage or the hurdle rate, is the figure over the duration of the investment or on an annual basis? 

 

Let's take the 10% example, what does that mean.... does it mean that if BAC Appreciates less than 10% a year  the strategy doesn't make sense ?  Or is it a measure of opportunity cost? Thanks

[racemize]

Eric, Race, when you guys talk about cost of leverage or the hurdle rate, is the figure over the duration of the investment or on an annual basis? 

 

Let's take the 10% example, what does that mean.... does it mean that if BAC Appreciates less than 10% a year  the strategy doesn't make sense ?  Or is it a measure of opportunity cost? Thanks

 

almost always talking about it at an annual rate, although I calculate both. 

 

The numbers above are a little tricky to spell out simply.  They represent the total return that would be gained by the common and/or the warrant for them to be equal.  However, it is a little difficult to think about total return sometimes, so I also calculate the common gain required to cause that total return. 

 

For example, for BAC-A, the total return required (including the time value of dividends) is 7.82% at current prices.  However, the common only needs to appreciate at 7.63% to achieve that total return.  I typically focus on the 7.63% number, as I can think of common stock appreciation in my head more easily than total return.

 

Actually, with these warrants the total return explanation isn't quite right easier.  It is the total return up to the dividend threshold, since everything after that is the same for the common and the warrant.

[ERICOPOLY]

Eric, Race, when you guys talk about cost of leverage or the hurdle rate, is the figure over the duration of the investment or on an annual basis? 

 

Let's take the 10% example, what does that mean.... does it mean that if BAC Appreciates less than 10% a year  the strategy doesn't make sense ?  Or is it a measure of opportunity cost? Thanks

 

Suppose you took out a loan from your family paying 7.5% interest rate.

 

You invest it into BAC for 12 months.

 

You break even if your total return from BAC (including dividends) is 7.5%.

 

7.5% is your cost of leverage -- that's the hurdle rate.

 

So embedded within the warrant is a synthetic loan.  The point where the returns from the warrant match the returns of the common is the cost of leverage.  It's where the costs from the leverage merely equate to the total return from the stock.

 

Anything above that total return "cost of leverage" rate, the leveraged approach will outperform the unleveraged common.  Anything less, and it will underperform.

 

So the whole point of a warrant is to earn leveraged returns.  Not leveraged losses!  So it's intelligent to think about how much the leverage in the warrant costs before deciding on that particular tool to drive your leveraged strategy.

 

 

[stahleyp]

eric, are you still in the warrants for your IRAs? thanks man!

[ERICOPOLY]

eric, are you still in the warrants for your IRAs? thanks man!

 

No, but only because I wanted to make a quick trade in SHLD.  Otherwise, I wouldn't have traded out of it.

[stahleyp]

Dude, why did you change your avatar from the girl to...a sea slug????  :D :D

[merkhet]

Dude, why did you change your avatar from the girl to...a sea slug????  :D :D

 

I feel like the switch was symbolic for his swapping out of BAC into SHLD. :P

[ERICOPOLY]

Dude, why did you change your avatar from the girl to...a sea slug????  :D :D

 

I feel like the switch was symbolic for his swapping out of BAC into SHLD. :P

 

Okay, I've updated the Avatar again.  I feel like this is more symbolic of the slide down the quality curve.

[stahleyp]

Dude, why did you change your avatar from the girl to...a sea slug????  :D :D

 

I feel like the switch was symbolic for his swapping out of BAC into SHLD. :P

 

Okay, I've updated the Avatar again.  I feel like this is more symbolic of the slide down the quality curve.

 

;D ;D ;D

[JSArbitrage]

Eric, Race, when you guys talk about cost of leverage or the hurdle rate, is the figure over the duration of the investment or on an annual basis? 

 

Let's take the 10% example, what does that mean.... does it mean that if BAC Appreciates less than 10% a year  the strategy doesn't make sense ?  Or is it a measure of opportunity cost? Thanks

 

Suppose you took out a loan from your family paying 7.5% interest rate.

 

You invest it into BAC for 12 months.

 

You break even if your total return from BAC (including dividends) is 7.5%.

 

7.5% is your cost of leverage -- that's the hurdle rate.

 

So embedded within the warrant is a synthetic loan.  The point where the returns from the warrant match the returns of the common is the cost of leverage.  It's where the costs from the leverage merely equate to the total return from the stock.

 

Anything above that total return "cost of leverage" rate, the leveraged approach will outperform the unleveraged common.  Anything less, and it will underperform.

 

So the whole point of a warrant is to earn leveraged returns.  Not leveraged losses!  So it's intelligent to think about how much the leverage in the warrant costs before deciding on that particular tool to drive your leveraged strategy.

 

Not to be nit-picky but this is not really your hurdle rate.  It's simply your cost of debt in this scenario.  You aren't compensating for the risk of the investment or your opportunity cost of foregoing other investments.  If this is your view, your hurdle rate is always your lowest cost of financing available which wouldn't theoretically makes sense. 

 

Remember, it's completely possible to make a profit on an investment but return less than your hurdle rate. 

[ERICOPOLY]

Eric, Race, when you guys talk about cost of leverage or the hurdle rate, is the figure over the duration of the investment or on an annual basis? 

 

Let's take the 10% example, what does that mean.... does it mean that if BAC Appreciates less than 10% a year  the strategy doesn't make sense ?  Or is it a measure of opportunity cost? Thanks

 

Suppose you took out a loan from your family paying 7.5% interest rate.

 

You invest it into BAC for 12 months.

 

You break even if your total return from BAC (including dividends) is 7.5%.

 

7.5% is your cost of leverage -- that's the hurdle rate.

 

So embedded within the warrant is a synthetic loan.  The point where the returns from the warrant match the returns of the common is the cost of leverage.  It's where the costs from the leverage merely equate to the total return from the stock.

 

Anything above that total return "cost of leverage" rate, the leveraged approach will outperform the unleveraged common.  Anything less, and it will underperform.

 

So the whole point of a warrant is to earn leveraged returns.  Not leveraged losses!  So it's intelligent to think about how much the leverage in the warrant costs before deciding on that particular tool to drive your leveraged strategy.

 

Not to be nit-picky but this is not really your hurdle rate.  It's simply your cost of debt in this scenario.  You aren't compensating for the risk of the investment or your opportunity cost of foregoing other investments.  If this is your view, your hurdle rate is always your lowest cost of financing available which wouldn't theoretically makes sense. 

 

Remember, it's completely possible to make a profit on an investment but return less than your hurdle rate.

 

I believe that I misuse terms because I'm not an educated CFA or a professional in this line of business.  To me the term make sense in the respect that if you don't clear the hurdle, you get hurt (thinking of a track and field hurdler).  It's not my aspirational rate of return (which is perhaps what the pros consider the hurdle rate).

[gary17]

In my mind whether the capital is deployed in warrants or commons or leaps.... there's always the opportunity cost question.

 

What I was simply asking is what Eric meant when he said "cost of leverage"...

 

The $10 2016 call is worth about $6.4 now....

If the commons to to $20 from 15.7 by this time next year, that's a 27%gain in one year. 

The options will probably be worth at least $10, maybe more like $11? Let's just say $10... so that's an appreciation from $6.40 or 56%... So options win.

 

But what Eric is saying I believe is if  BAC only appreciates to $16.5, then the commons gain 5% while the options probably stay at $6.4ish or no gain at all... is this the situation where it is not worth using the options? am I understanding this logic right? 

 

I'm trying to understand this in as simple a term as possible. 

 

 

If I understand this correctly. Then the investment decision should then be based on what the probability of BAC shares staying at about $16 vs appreciating to $20....

 

Thanks

[ERICOPOLY]

In my mind whether the capital is deployed in warrants or commons or leaps.... there's always the opportunity cost question.

 

What I was simply asking is what Eric meant when he said "cost of leverage"...

 

The $10 2016 call is worth about $6.4 now....

If the commons to to $20 from 15.7 by this time next year, that's a 27%gain in one year. 

The options will probably be worth at least $10, maybe more like $11? Let's just say $10... so that's an appreciation from $6.40 or 56%... So options win.

 

But what Eric is saying I believe is if  BAC only appreciates to $16.5, then the commons gain 5% while the options probably stay at $6.4ish or no gain at all... is this the situation where it is not worth using the options? am I understanding this logic right? 

 

I'm trying to understand this in as simple a term as possible. 

 

 

If I understand this correctly. Then the investment decision should then be based on what the probability of BAC shares staying at about $16 vs appreciating to $20....

 

Thanks

 

Gary, if you borrow money from the bank at 5% to purchase more shares, then your "cost of leverage" is 5%.

 

There is an options premium -- think of this is prepaid interest for the loan term.  There is a strike price -- think of this as the amount borrowed.  Any missed dividends are also a cost of this form of leverage -- an additional cost of borrowing the amount indicated by the strike price.

 

Is it clear now?

[kmukul]

Hi Eric,

I can understand what you are saying about puts However i dont understand a few things, Why would you buy those if you expect to lose money on them, there are better ways of losing money. I think with BAC buyback program buffet behind and other changes in earnings as they are coming up bac is chance of going to tank close below 10$ is very low you might want that protection if you are on margin but other then that i dont see a reason for that,

 

Also you said you bought 12$ puts to protect your investment when you bought stock at 12$ but as the price moves up lets say 20$ in coming years why buy 12$ put again. it might make sense to buy 15$ put or higher if you really want to protect yourself from downside.

 

[ERICOPOLY]

Hi Eric,

I can understand what you are saying about puts However i dont understand a few things, Why would you buy those if you expect to lose money on them, there are better ways of losing money. I think with BAC buyback program buffet behind and other changes in earnings as they are coming up bac is chance of going to tank close below 10$ is very low you might want that protection if you are on margin but other then that i dont see a reason for that,

 

I bought them so that I could limit the downside to a small amount, while keeping most of the upside.  Then I leveraged it while containing the risk from the leverage.

 

I am on margin -- so I do in fact need it.  The tax laws encourage margin because they take away my money if I sell -- so I have to borrow instead.

 

 

Also you said you bought 12$ puts to protect your investment when you bought stock at 12$ but as the price moves up lets say 20$ in coming years why buy 12$ put again. it might make sense to buy 15$ put or higher if you really want to protect yourself from downside.

 

I agree.  And I will roll to $15 strike when they are sufficiently cheap.  Right now, it costs 7.9% to purchase $15 strike puts.  That cost will continue to come down as the stock goes up.  In March, when this thread began, it cost 13% to hedge at $13.30 via the warrants.  So now it is vastly cheaper to go with the higher strike $15 put.  Like I said back then, it didn't make sense to prepay 6 years of put cost when the stock price was sure to soon rise (it was, at least, what we expected).

 

 

[gary17]

Hi Eric

When you bought the $12 puts - how much was the share price of BAC and the premium of the puts.  I just want to get an idea of how much cheaper it got during this time as the BAC commons appreciated....   

 

thanks

Gary