Abstract: The 60/40 bond to stock split has been a permanent piece of investing advice. We analyze this strategy using a 10-year bond versus a bond/option strategy discussed in a previous post. Then we discuss how we could add options to the bond/stock strategy to help increase yields.

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Disclaimer: This is a thought experiment and whether it is right for your portfolio is up to you or a discussion with your financial advisor.

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Introduction

One of the most common strategies for wealth preservation and building capital is the idea of splitting money between bonds and stocks. If you are unfamiliar with a bond, please see this article. In this article, we will use the same nomenclature as the previous article and continue examining a portfolio with X = $1m with "stocks" being represented by SPY (or the performance of the market).

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At the current time of writing, interest rates are greater than 4%. So, if an investor chose a 10-year bond, it would provide the advised 60/40 split. Take X= $1m, a 10-year bond at 4% would be around $60, and so to purchase a face value of X, one would pay $600,000. If the other $400,000 were placed in SPY, then regardless of the performance of the stock market, the portfolio value at the end of 10-years will be:

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PORTFOLIO A: X + (1+% value change in spy)*0.4X

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That is because the bond matures to X, and after 10-years we are still holding the stock market, which has presumably gone up in this amount of time. Even if not, unlike with options, at the end of term you still have the value of the stock even if the market went below purchase value.

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The tradeoff is the guaranteed gains in the bond for lower yield as our 2-year bond/option strategy was offering a yield proportional to the market at about 60%, but at the cost of the bond's interest to purchase the option.

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Purchasing Parity

What if we could use options to purchase our 60% bond portfolio in 2-year call option on SPY?

Using the formula from the previous article, the amount would be 0.6X(OP/SP).

Let's consider our example and prices from the prior article. In this case D=(0.6* X) and OP/SP = 0.135. When X= $1M, then 0.60*0.135*X=0.081*X or 8.1%. Therefore, splitting the portfolio 60/31.9/8.1 would allow us (for a period of 2-years) to replicate the market at 91.5% ratio by purchasing an option.

The return on the example above for two years looks like:

PORTFOLIO B: 0.68X + 0.319X*(1+% of market return) + 0.6* X(% of market return with no losses below strike price).

At the end of 10-years, the fee is recouped if it is lost, having said this with the increase returns for the average year, it would allow the investor to receive a significant increase in gains. The average gain since 2010 has been 20% year over year. To be conservative, let's consider a 2 year period with just a 20% gain over 2 years. For comparison, let's consider Portfolio C: $X in SPY

PORTFOLIO A after 2-years would yield 0.68*X +0.4(1.2)X = 0.68X+(0.48X)=1.16*X or 1.16M

PORTFOLIO B after 2-years would yield 0.68X + 0.319 X (1.2) +0.6X (0.2) - = 0.68X +.3828*X + .12X= 1.1828*X

PORTFOLIO C after 2-years would yield 1.2X or $1.2M

A 30% 2-year return.

PORTFOLIO A after 2-years would yield 0.68*X +0.4(1.3)X = 0.68X+(0.52X)=1.2*X or 1.2M

PORTFOLIO B after 2-years would yield 0.68X + 0.319 X (1.3) +0.6X (0.3)  = 0.68X +.4147*X + .18X= 1.2747

PORTFOLIO C after 2-years would yield 1.3X or $1.3M

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At a 40% 2-year return on SPY

PORTFOLIO A after 2-years would yield 0.68*X +0.4(1.4)X = 0.68X+(0.56X)=1.24*X or 1.24M

PORTFOLIO B after 2-years would yield 0.68X + 0.319 X (1.4) +0.6X (0.4)  = 0.68X +.4466X + .24*X = 1.3666*X

PORTFOLIO C after 2-years would yield 1.4X or 1.4M

Because the option costs about 13.5%, a 13.5% gain in the market over 2-yearswould be "break even" otherwise the portfolio is incurring losses on the options.

Conclusion:

Using options to rent 60% of the market provides extra yields. At a 30% gain over 2 years, it is about 7.4% more, at a 40% gain it is about 12.6% more. A 60/30/10 split will give us a slight market over exposure better approximating market returns.