The Bond Market Shows Value in This Stock
In the trading world, the bond market has a unique reputation. That’s the market where the smartest traders historically battled each other. Bonds require different skills than stocks because they are more complex instruments with different covenants governing each bond.
In addition to the fact that each bond has unique characteristics, the math required to value a bond is a little more complex than the math associated with stocks. Bond traders need to understand when and under what circumstances a company can redeem the debt. Stocks are perpetual instruments.
Bonds also tend to be more expensive to trade than stocks. Commissions can be hidden in the bid and ask prices and many bonds rarely trade. A lack of transparency in a market tends to make it more expensive.
All of these features have led to bond markets having a reputation as all knowing and unforgiving. When Bill Clinton was running for President, his campaign strategist, James Carville, famously remarked on the power of the bond market:
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This reputation is well deserved and even if traders aren’t buying and selling individual bonds, they can still benefit from developments related to bonds.
Refinancing Offers Insights to Financial Health
Bond markets, at times, act like mortgage brokers. When a company seeks to issue debt, investment firms managing the offering will review the financial statements to determine how likely the company is to repay the debt. This is more complex than a consumer credit score, but similar in some ways.
This process leads to the pricing of the bond offering. Investors want to be compensated for risk and demand higher interest rates from riskier companies. That means as a company’s financial status improves, they may refinance debt to decrease their interest expense.
Consumers behave in a similar way. If they have a mortgage and interest rates drop, they may refinance. They only refinance when their credit history is strong and the reduction in rates offers significant savings.
For a publicly traded company, it might take just a small drop in interest rates to generate a significant savings in the amount of interest paid. That’s the case for Western Digital Corporation (Nasdaq: WDC) which recently announced that it has successfully priced $2.963 billion of debt.
The new debt carries an interest rate of LIBOR + 2.00%. LIBOR stands for London Interbank Offered Rate and is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It serves as the first step to calculating interest rates on various loans throughout the world.
In this offering, WDC will pay 2% more than the LIBOR rate which is currently 1.6%.
The debt is rated B-3, in a category commonly known as junk but more formally called non-investment grade.
Western Digital used this bond offering to refinance an earlier debt offering. The previous bonds were priced at LIBOR + 2.75% so the company will save 75 basis points, or 0.75% per year.
The new financing is expected to generate annual cash interest savings of approximately $22 million beginning on Nov. 8, 2017, resulting solely from the 75 basis point reduction in the interest rate spread.
This news indicates that Western Digital is improving its financial health. That should lead to increased earnings and the next earnings report should show the benefit of this transaction. That report is expected in late January.
In the meantime, the stock is likely to settle into a trading range. In fact, the stock has been in a trading range for some time.
The price chart shows that WDC has been trading between about $82 on the low end of the range and $90 on the high end of the range since August. This range could continue until a catalyst pushed the stock higher or lower, and the potential catalyst of an earnings report is months away.
One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Western Digital
For Western Digital, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, December 1.
The difference in the exercise prices of the calls or puts is equal to $2.50. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $250 less the premium received when the trade was opened.
Selling the options will generate $2.55 in income ($1.70 from the call and $0.85 from the put). Buying the options will cost $1.30 ($0.80 for the call and $0.50 for the put). This means opening the trade will result in a credit of $1.25, or $125 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($2.50) minus the premium received ($1.25). This is equal to $1.25, or $125 since each contract covers 100 shares. Most brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $125 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $1.25 or $125 per contract.
The potential reward on the trade ($125) is 100% of the amount risked, a high potential return on investment for a trade that will be open for less than a month. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.